WWS 408 Final Review

Arrow-Debreu Model

1. Each agent is endowed with resources and technology 2. Rational expected utility maximization through trading of securities by economic agents 3. A world where market prices are decided through an auction for securities that are promises to pay or rights to receive goods or money exchangeable for goods at known prices in a given time and "state of nature" 4. Agents buy and sell to make their marginal utility if a state of nature occurs in a given time period times the probability of that state occurring in the time period proportional to the price. 5. Prices will incorporate discount rates (with further future states having lower prices) 6. Diminishing marginal utility for any good in any time and state of nature implies risk aversion 7. Markets set prices to equate supply and demand

Financial System Oversight Committee

1. Established by Dodd-Frank 2. Chaired by the Secretary of the Treasury 3. Can make some operational decisions 4. Supported by an Office of Financial Research

Domestic bond

A bond issued in the domestic currency by a domestic entity

Junk bond

A high-risk high-yield bond with a credit rating below BBB (S&P) or Baa (Moody's)

Securities market line

A line which measures the relationship between beta (or systematic risk) and firm's expected rate of return

Fundamental-valuation efficiency

A market in a financial asset is efficient in this sense if its valuations reflect accurately the future payments to which the asset gives title

Information-arbitrage efficiency

A market is efficient in this sense if it is on average impossible to gain from trading on the basis of generally available public information

Market liquidity

A market's ability to facilitate an asset being sold quickly without having to reduce its price very much (or even at all).

Warrant

A medium- or long-term option attached to a bond that gives the holder the right to buy or sell a security at a given price; warrants can be detached from the bond and sold separately

Market Portfolio

A portfolio made up of all the assets in the economy with weights equal to their relative market values

Intermediate-term maturity

Between one year and ten years

Maturity

Characteristic of a debt instrument: number of years (term) until that instrument's expiration date

Primary market

Financial market in which new issues of a security are sold to initial buyers by the corporation or government agency borrowing the funds

Money market

Financial market in which only short-term debt instruments are traded

Secondary market

Financial market in which securities that have been previously issued can be resold

Investment bank

Guarantees a price for an entity's securities and sells them to the public, a process known as underwriting

Liabilities

IOUs or debts

Shafer on Informational efficiency

If all information available to anyone is widely (not necessarily universally) available costlessly, it is impossible to make supernormal returns consistently

Chapter 6 of "Finance and Financial Markets" by Kenneth Pilbeam

Information on the following: 1. pricing of Treasury bonds and their relationship with long-term interest rates 2. meaning of yield-to-maturity 3. bond price volatility and the meaning of duration 4. economic significance of the yield curve 5. role of the credit rating agencies 6. difference between domestic, foreign and Eurobonds

Chapter 8 of "Finance and Financial Markets" by Kenneth Pilbeam

Information on the following: 1. the market model and the difference between systematic and unsystematic risk 2. the theory behind the capital asset pricing model (CAPM) 3. the empirical evidence concerning the CAPM 4. the multifactor CAPM model 5. criticisms of the CAPM model 6. the arbitrage pricing theory (APT)

Chapter 7 of "Finance and Financial Markets" by Kenneth Pilbeam

Information on the following: 1. tradeoff between risk and return 2. difference between systematic and unsystematic risk 3. benefits from portfolio diversification 4. importance of the market portfolio 5. the market price of risk and how to measure it 6. measuring the benefits of portfolio diversifciation

Corporate bonds

Issued by corporations that wish to raise funds for various purposes

Short-term maturity

Less than one year

Dealers

Link buyers and sellers by buying and selling securities at stated prices

Capital market

Market in which longer-term debt and equity instruments are traded

Clean bond price

The price excluding accrued interest

Naive Diversification

The process of investing in a variety of securities and assets in equal value-weighted proportions

Efficient Diversification

The process of investing in variety of securities and assets taking into account the covariances and variances of the securities and assets to achieve optimal risk-return portfolios

Fat tail

1. A form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. 2. When a portfolio of investments is put together, it is assumed that the distribution of returns will follow a normal pattern. Under this assumption, the probability that returns will move between the mean and three standard deviations, either positive or negative, is 99.97%. This means that the probability of returns moving more than three standard deviations beyond the mean is 0.03%, or virtually nil. However, the concept of tail risk suggests that the distribution is not normal, but skewed, and has fatter tails. The fatter tails increase the probability that an investment will move beyond three standard deviations. Distributions that are characterized by fat tails are often seen when looking at hedge fund returns.

Brokers

Agents of investors who match buyers with sellers of securities

Equities

Claims to share in the net income and assets of a business. Has lower status than debt instruments in case of default

States of Nature

Different scenarios of how events unfold

Repurchase agreeements (repos)

Effectively short-term loans (usually with a maturity of less than two weeks) for which Treasury bills serve as collateral

Relationship between yield and the price of the bond

Negative and convex

Adverse Selection

Occurs when those most likely to default seek out a loan: namely, self-selection gone wrong

Asymmetric information

One or more parties may be privy to information unknown by the individual or organizations with which the aforementioned parties are contracting

Dividends

Periodic payments of equities

Call provision

Permits the issuer to buy back all or part of the issue prior to maturity

Source of Problems with CAPM

Problems arise not from its use but from its exclusive use, as 1. It was not designed to look at systemic risk 2. History has information that should get weight in markets and their regulation 3. Non-normal distributions need attention (and are getting more)

"An Overview of the Financial System" by Frederic Mishkin

Provides an overview of what financial markets do and the institutions and instruments in them

Default

Situation in which the party issuing the debt instrument is unable to make payments or pay off the amount owed when the instrument matures

Market Risk

Risk that is inherent in market fluctuations and that cannot be diversified away

Specific Risk

Risk that is specific to a particular security and which can be reduced by increasing the number of shares since positive and negative shocks affecting individual companies will tend to cancel each other out

Asset transformation

Risky assets are turned into safer assets for investors

Commercial paper

Short-term debt instrument issued by large banks and well-known corporations

Long-term maturity

Ten years or longer

Dirty bond price

The actual price paid for the bond: dirty price is clean price plus the total accrued interest to which the bond holder would be entitled for holding the bond between bond payments

Risk

The danger that the rate of return on the security will be less than the investor expects when purchasing the security

Covariance or correlation

The extent to which two or more assets move up and down together

Knight's Definition of Uncertainty

Uncertainty deals with the unquantified

Capital

Wealth, either financial or physical, which is used to produce more wealth

Net Stable Funding Ratio Debate

Debate between banks and regulators about the right measure

Distress and Systemic Liquidity

Distress can bring collapse of systemic liquidity (and it did in 2007-2009) 1. Liquidity of assets declined—they could be sold only at depressed "fire sale" prices 2. Credit dried up because lenders were stressed (the repo market) 3. "Haircuts" (how much a position needs to be over collateralized) rose, using up liquidity 4. Depressed asset prices impaired credit worthiness 5. Options embedded in debt in good times forced repayment in tough times (ratings puts)

CDO

...

Financial Innovation

...

RMBS

...

SIV

...

The Gramm-Leach-Bliley Act

...

Business conduct in the objectives approach of the US Treasury 2008

1. Protection of consumers (retail investors) 2. Provide a level playing field 3. Fight predatory practices

Problems associated wth Strict (Non-relaxable) Leverage and Capital Ratios

1. An iron law just moves the point at which failure occurs 2. But there may be less draconian official responses than resolution (shutting the institution down) 3. Nevertheless, there are tradeoffs in the choice between rules and discretion

Hedging

1. Hedging is taking on one risk that offsets another 2. Hedging instruments include futures, derivatives, options and CDS 3. Hedging can crate new risks such as counterparty risk, need to post collateral and basis risk

401K

1. A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren't paid until the money is withdrawn from the account. 2. 401(k) plans, named for the section of the tax code that governs them, arose during the 1980s as a supplement to pensions. Most employers used to offer pension funds. Pension funds were managed by the employer and they paid out a steady income over the course of the retirement. (If you have a government job or a strong union, you may might still be eligible for a pension.) But as the cost of running pensions escalated, employers started replacing them with 401(k)s. 3. With a 401(k), you control how your money is invested. Most plans offer a spread of mutual funds composed of stocks, bonds, and money market investments. The most popular option tends to be target-date funds, a combination of stocks and bonds that gradually become more conservative as you reach retirement. 4. While a 401(k)can help you save, it has plenty of restrictions and caveats. In most cases, you can't tap into your employer's contributions immediately. Vesting is the amount of time you must work for your company before gaining access to its payments to your 401(k). (Your payments, on the other hand, vest immediately.) It's an insurance against employees leaving early. On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age. 5. To oversee your account, your employer usually hires an administrator like Fidelity Investments. They'll email you updates about your plan and its performance, manage the paperwork and assist you with requests. If you want to keep watch over your account or shift your money around, go to your administrator's web site or call their help center.

Government National Mortgage Association (GNMA or Ginnie Mae)

1. A U.S. government corporation within the U.S. Department of Housing and Urban Development (HUD). Ginnie May aims to: A) Ensure liquidity for government-insured mortgages, including those insured by the Federal Housing Administration (FHA), the Veterans Administration (VA) and the Rural Housing Administration (RHA), B) Bring investors' capital into the market for these types of loans, so that the issuers have the means to issue more. 2. Most of the mortgages securitized as Ginnie Mae mortgage-backed securities (MBSs) are those guaranteed by FHA, which are typically mortgages for first-time home buyers and low-income borrowers. 3. Ginnie Mae neither issues, sells or buys pass-through mortgage-backed securities, nor does it purchase mortgage loans. It simply guarantees (insures) the timely payment of principal and interest from approved issuers (such as mortgage bankers, savings and loans, and commercial banks) of qualifying loans, such as those issued by the FHA and RHA. 4. Unlike its cousins Freddie Mac, Fannie Mae and Sallie Mae, Ginnie Mae is not a publicly-traded company. An investor in a GNMA security will not know who the underlying issuer of the mortgages is, but merely that the security is guaranteed by GNMA, which is backed by the full faith and credit of the U.S government, just like U.S. Treasuries.

Foreign Corrupt Practices Act (defined)

1. A United States law passed in 1977 which prohibits U.S. firms and individuals from paying bribes to foreign officials in furtherance of a business deal and against the foreign official's duties. The FCPA places no minimum amount for a punishment of a bribery payment. The Foreign Corrupt Practices Act also specifies required accounting transparency guidelines. 2. While the act requires corrupt intent, it is better to err on the side of caution when dealing with a foreign official for business matters. Punishments allowable under the act include fines of up to double the amount of the benefit expected to be received from the bribery. In addition, the individuals involved can face imprisonment for up to five years.

Liquidity and bubbles

1. A bubble is fed by easy liquidity e.g. gold discovery, easy monetary policy 2. But it also requires a "good story" e.g. home prices will rise forever 2002-2006 3. And it is often fed by financial innovation e.g. structured products in subprime bubble

"Reassessing the impact of finance on growth" by Stephen Cecchetti and Enisse Kharroubi

1. A careful econometric analysis of the effect of finance on productivity with surprising results. 2. Based on a sample of developed and emerging economies, authors show that 1) the level of financial development is good only up to a point, after which it becomes a drag on growth and 2) in advanced economies, a fast-growing financial sector is detrimental to aggregate productivity growth

"The virtues and vices of equilibrium and the future of financial economics" by J. Doyne Farmer and John Geanakoplos

1. A critique of economists' models of finance by two people who really understand them 2. They argue that in situations where 1) the cognitive task to be solved is relatively simple, 2) there is good information available for model formation, and 3) the estimation problems are tractable, rational expectations equilibrium is likely to provide a good explanation e.g. option pricing, hedging, or the pricing of mortgage- backed securities 3. In other cases where 1) the cognitive task is extraordinarily complex or 2) estimation problems are severe, human models may diverge significantly from rational models, and the equilibrium framework may be a poor approximation

Volcker Rule

1. A federal regulation that prohibits banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds, also called covered funds. The Volcker Rule's purpose is to prevent banks from making certain types of speculative investments that contributed to the 2008 financial crisis. 2. Disallows short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for banks' own accounts under the premise that these activities do not benefit banks' customers. In other words, banks cannot use their own funds to make these types of investments to increase their profits. 3. The rule allows banks to continue market making, underwriting, hedging, trading of government securities, insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers or custodians. Banks may continue to offer these services to their customers and generate profits from providing these services. However, banks cannot engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or within the overall U.S. financial system. 4. Depending on their size, banks must meet varying levels of reporting requirements to disclose details of their covered trading activities to the government. Larger institutions must implement a program to ensure compliance with the new rules, and their programs will be subject to independent testing and analysis. Smaller institutions are subject to lesser compliance and reporting requirements.

Federal National Mortgage Association (FNMA or Fannie Mae)

1. A government-sponsored enterprise (GSE) that was created in 1938 to expand the flow of mortgage money by creating a secondary mortgage market. Fannie Mae is a publicly traded company which operates under a congressional charter that directs Fannie Mae to channel its efforts into increasing the availability and affordability of homeownership for low-, moderate- and middle-income Americans. 2. Fannie Mae purchases and guarantees mortgages that meet its funding criteria. Through this process it secures mortgages to form mortgage-backed securities (MBS). The market for Fannie Mae's MBS is extremely large and liquid. Pension funds, insurance companies and foreign governments are among the investors in Fannie Mae's MBS. In order to promote homeownership, Fannie Mae also holds a large portfolio of its own and other institution's MBSs, known as its retained portfolio. To fund this portfolio, Fannie Mae issues debt known in the market place as agency debt. 3. Fannie Mae's "little brother" is Freddie Mac. Together, Fannie Mae and Freddie Mac purchase or guarantee between 40 to 60% of all mortgages originated in the United States annually, depending upon market conditions and consumer trends.

Liquidity as the capacity to make payments in the short runliquidity and solvency of an institution

1. A liquid institution is one that can meet current demands on it for payment 2. It may be insolvent—that is have a negative net worth—several life insurance companies in March 2009 when the stock market hit its low. 3. A solvent institution may become illiquid—institutions may not be able to borrow or sell assets because of market conditions when they have long term assets that in normal conditions would be valued much higher than its liabilities 4. A liquidity stressed institution will become insolvent without relief as it pays abnormally high interest rates or foregoes abnormally high returns to raise cash

Money Market Mutual Funds: Regulatory failure

1. A majority of the SEC have refused to approve measures to either drop the fixed dollar valuation or provide value or liquidity buffers 2. Measures had the backing of the White House, Treasury officials, the Federal Reserve, the Bank of England, a council of academic experts, The Wall Street Journal's conservative editorial page, former Fed chairman Paul Volcker, former Treasury Secretary Henry M. Paulson Jr. and the conservative Shadow Financial Regulatory Committee 3. Intense industry lobbying resulted in opposition by two Republicans and one Democrat on the Commission 4. Luis Aguilar, a Democratic Commissioner who formerly served as an executive of Invesco, a company that manages MMMFs, was the swing vote.

What should be the focus in developing a capacity to reduce systemic risk?

1. A mandate to collect more data to spot building imbalances and crowded trades 2. Look at collective risks as well as at SIFIs—"crowded trades" 3. Systemic stress tests (data must come first) 4. Focus on unintended consequences of market and regulatory innovation 5. Move from procyclical to anticyclical capital and liquidity requirements 6. Look at market infrastructure

Mark-to-market

1. A measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation. 2. The accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value. 3. When the net asset value (NAV) of a mutual fund is valued based on the most current market valuation. 4. Problems can arise when the market-based measurement does not accurately reflect the underlying asset's true value. This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis. For example, if the liquidity is low or investors are fearful, the current selling price of a bank's assets could be much lower than the actual value. The result would be a lowered shareholders' equity. 5. This issue was seen during the financial crisis of 2008/09 where many securities held on banks' balance sheets could not be valued efficiently as the markets had disappeared from them. In April of 2009, however, the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting in the first quarter of 2009. 6. This is done most often in futures accounts to make sure that margin requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call. 7. Mutual funds are marked to market on a daily basis at the market close so that investors have an idea of the fund's NAV.

The cycle of creative destruction (Joseph Schumpeter)

1. A new way of doing business: A) Creates super normal profits for the innovator, B) Destroys profits of competing firms doing things the old way 2. Innovation is imitated: A) Supernormal profits are eroded by increased competition from imitators, B) Patents, copyrights and secrecy may slow the rise of competition, but it rarely, if ever, stops it 3. Drive for new innovation to sustain profits: A) May take the form of building more risk into the new process—heightened risk of distress, B) Incumbents may undertake change that can also create risk 4. May lead to new innovations that start the cycle over 5. But innovations usually outlive the conditions that created them once they are firmly established (money market mutual funds)

What View of LOLR as Monetary Policy in Disturbed Times Misses

1. A potential need to offset an increase in money (liquidity) demand in distress 2. A potential need to target lending when interbank or other wholesale markets break down

"The Dog and the Frisbee" by Andrew Haldane

1. A reflection on the relationship between economic theory and reality by a policymaker trained as an economist 2. Modern finance is complex, perhaps too complex 3. Regulation of modern finance is complex, almost certainly too complex 4. That configuration spells trouble: don't fight fire with fire, complexity with complexity 5. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.

Defined contribution retirement plan

1. A retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee. There are restrictions as to when and how you can withdraw these funds without penalties. 2. There is no way to know how much the plan will ultimately give the employee upon retiring. The amount contributed is fixed, but the benefit is not.

Problems created by junk bonds

1. Domination of market by Drexel had consequences: A) created environment for questionable business practices, B) There were no wholesale market participants to absorb Drexel's holdings when it came under pressure following conviction 2. Controversy over role in hostile takeovers

Asymmetric information (Defined)

1. A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party's lack of knowledge. 2. Information Asymmetry can lead to two main problems: A) Adverse selection- immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not be in optimal health may be more inclined to purchase life insurance than someone who feels fine. B) Moral Hazard- immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance.

Runs

1. A situation that occurs when a large number of bank or other financial institution's customers withdraw their deposits simultaneously due to concerns about the bank's solvency. As more people withdraw their funds, the probability of default increases, thereby prompting more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals. A bank run is typically the result of panic, rather than a true insolvency on the part of the bank; however, the bank does risk default as more and more individuals withdraw funds - what began as panic can turn into a true default situation. 2. Because banks typically keep only a small percentage of deposits as cash on hand, they must increase cash to meet depositors' withdrawal demands. One method a bank uses to quickly increase cash on hand is to sell off its assets, sometimes at significantly lower prices than if it did not have to sell quickly. Losses on selling the assets at lower prices can cause a bank to become insolvent. A "bank panic" occurs when multiple banks endure runs at the same time. 3. In the United States, the Federal Deposit Insurance Corporation (FDIC) is the agency that insures banking deposits. It was established by Congress in 1933 in response to the many bank failures that happened in the 1920s. Its mission is to maintain stability and public confidence in the U.S. financial system.

Incentive alignment

1. A stock option granted to specified employees of a company. ESOs carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price. An employee stock option is slightly different from a regular exchange-traded option because it is not generally traded on an exchange, and there is no put component. Furthermore, employees typically must wait a specified vesting period before being allowed to exercise the option. 2. The idea behind stock options is to align incentives between the employees and shareholders of a company. Shareholders want to see the stock appreciate, so rewarding employees when the stock goes up ensures, in theory, that everyone is striving for the same goals. Critics point out, however, that there is a big difference between an option and the ownership of the underlying stock. If the stock goes down, the holder of an option would lose the opportunity for a bonus, but wouldn't feel the same pain as the owner of the stock. This is especially true with employee stock options because they are often granted without any cash outlay from the employee.

Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

1. A stockholder-owned, government-sponsored enterprise (GSE) chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans. The FHLMC purchases, guarantees and securitizes mortgages to form mortgage-backed securities. The mortgage-backed securities that it issues tend to be very liquid and carry a credit rating close to that of U.S. Treasuries. 2. Freddie Mac has come under criticism because its ties to the U.S. government allows it to borrow money at interest rates lower than those available to other financial institutions. With this funding advantage, it issues large amounts of debt (known in the market place as agency debt or agencies), and in turn purchases and holds a huge portfolio of mortgages known as its retained portfolio. Many people believe that the size of the retained portfolio poses a great deal of systematic risk to the entire U.S.

Crashes

1. A sudden and significant decline in the value of a market. A crash is most often associated with an inflated stock market. Causes for a crash may include an economic bubble in which securities, or other investments, are trading at prices far above their intrinsic value, or a highly-leveraged market in which debt is used to finance further investment. Crashes are distinguishable from a bear market by their rapid decline in a number of days, rather than a decline over a longer period of time. A crash can lead to a depression in the overall economy and subsequent bear market. 2. A crash is both an economic phenomenon and a psychological one. Investors who see a rapid decline in the value of a particular stock may sell off other securities as well, leading to the possibility of a vicious spiral marked by negative crowd behavior. In order to reduce the effect of a crash, many stock markets employ circuit breakers designed to halt trading if declines cross certain thresholds.

Full-insurance efficiency

1. A system of financial markets is efficient in this sense if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies 2. Completeness of markets at issue here

Policy Concern 2: Complexity

1. An issue of sheer size as well as scope 2. Little research on the economic costs of complexity in a financial institution: A) The only cited study uses number of subsidiaries as the measure of complexity—hardly a robust measure, B) Still, it is hard to believe that complexity does not lead to rising marginal cost as more activities are integrated, C) Deliberate development may yield comparative advantage in managing a particular complexity, D) Citibank as a specialist in multicountry banking going back more than 100 years 3. Complexity costs should be reflected in market valuations: Is there a need for regulation to deal with this concern? Is the Bank of America capital reporting error an example of excess institutional complexity or regulatory complexity?

"What is the contribution of the financial sector: Miracle or mirage?" by Andrew Haldane, Simon Brennan and Vasileios Madouros

1. A thorough post-crisis statistical reexamination of the contribution of finance to the economy. 2. Authors consider the contribution made by the financial sector to the wider economy 3. The measured GDP contribution of the financial sector suggests it underwent a"productivity miracle" from the 1980s onwards, as finance rose as share of national output despite a declining labor and capital share 3. Analysis of returns to banking suggests otherwise: much of the growth reflected the effects of higher risk-taking 4. Leverage, higher trading profits and investments in deepout-of-the-money options were the risk-taking strategies generating excess returns to bank shareholders and staff 5. Subsequently, as these risks have materialized, returns to banking have reversed. In this sense, high pre-crisis returns to finance may have been more mirage than miracle 6. This suggests better measuring of risk-taking in finance is an important public policy objective

Subprime Mortgage Credit

1. A type of mortgage that is normally made out to borrowers with lower credit ratings. As a result of the borrower's lowered credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk. 2. Borrowers with credit ratings below 600 often will be stuck with subprime mortgages and the higher interest rates that go with those mortgages. Making late bill payments or declaring personal bankruptcy could very well land borrowers in a situation where they can only qualify for a subprime mortgage. Therefore, it is often useful for people with low credit scores to wait for a period of time and build up their scores before applying for mortgages to ensure they are eligible for a conventional mortgage.

Foreign Corrupt Practices Act

1. Affects all international US businesses in the same way 2. An international policy (other laws apply to corrupt payments to government officials at home) 3. Has moved from a unilateral US policy to one embedded in international agreements

Why a more objectives oriented structure would be better for US financial regulatory system

1. Agency leadership would be judged by and focus more on objectives 2. Objectives do not align closely with either institutional structure in the markets or agency structure now—gaps and overlap prevail e.g. the Fed and SEC—different philosophies reflect objectives considered most important in the past 3. Turf battles would be about important issues—weight given to different objectives when tradeoffs must be made 4. Likely outcome a "Nash Equilibrium" for policy—not optimal, but not bad 5. A strong coordination process could nudge from Nash Equilibrium to Pareto Optimal solution

Principal-agent problem

1. Aligning incentives with interests of the principals 2. Mis-measurement and non-measurement 3. Intensity of incentives 4. Short term versus long term 5. Asymmetrical information

Glass Steagall Act

1. An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment banking business. The Glass-Steagall Act was sponsored by Senator Carter Glass, a former Treasury secretary, and Senator Henry Steagall, a member of the House of Representatives and chairman of the House Banking and Currency Committee. The Act was passed as an emergency measure to counter the failure of almost 5,000 banks during the Great Depression. The Glass-Steagall lost its potency in subsequent decades and was finally repealed in 1999. 2. Apart from separating commercial and investment banking, the Glass-Steagall Act also created the Federal Deposit Insurance Corporation, which guaranteed bank deposits up to a specified limit. The Act also created the Federal Open Market Committee and introduced Regulation Q, which prohibited banks from paying interest on demand deposits and capped interest rates on other deposit products (it was repealed in July 2011). 3. The Glass-Steagall Act's primary objectives were twofold - to stop the unprecedented run on banks and restore public confidence in the U.S. banking system; and to sever the linkages between commercial and investment banking that were believed to have been responsible for the 1929 market crash. The rationale for seeking the separation was the conflict of interest that arose when banks were engaged in both commercial and investment banking, and the tendency of such banks to engage in excessively speculative activity. 4. The Glass-Steagall Act's repeal in 1999 is believed in some circles to have contributed to the 2008 global credit crisis. Commercial banks, around the world, were saddled with billions of dollars in losses due to the excessive exposure of their investment banking arms to derivatives and securities that were tied to U.S. home prices. The severity of the crisis forced Goldman Sachs and Morgan Stanley, the last of the top-tier independent investment banks, to convert to bank holding companies. Coupled with the acquisition of other prominent investment banks Bear Stearns and Merrill Lynch by commercial banking giants JP Morgan and Bank of America, respectively, the 2008 developments ironically signaled the final demise of the Glass-Steagall Act.

Stress tests

1. An analysis conducted under unfavorable economic scenarios which is designed to determine whether a bank has enough capital to withstand the impact of adverse developments. Stress tests can either be carried out internally by banks as part of their own risk management, or by supervisory authorities as part of their regulatory oversight of the banking sector. These tests are meant to detect weak spots in the banking system at an early stage, so that preventive action can be taken by the banks and regulators. 2. Stress tests focus on a few key risks - such as credit risk, market risk, and liquidity risk - to banks' financial health in crisis situations. The results of stress tests depend on the assumptions made in various economic scenarios, which are described by the International Monetary Fund as "unlikely but plausible." Bank stress tests attracted a great deal of attention in 2009, as the worst global financial crisis since the Great Depression left many banks and financial institutions severely under-capitalized. 3. Bank stress tests showed banks had sufficient capital and helped restore faith in the financial system

Bubbles

1. An asset-price bubble—if one exists—represents a mispricing of asset values relative to prices that would be consistent with the existence of efficient markets 2. Bubbles considered rest on the possibility of heterogeneous beliefs and the existence of market participants who can be considered behavioral traders 3. Bubbles often start with some exogenous factor that can be interpreted rationally as presenting large future prospects for profit 4. Bubble not pricked because arbitrage not only expensive but also risky and also smart money rides along with the dumb money (Malkiel)

"The Woman Who Took the Fall for JPMorgan Chase" by Susan Dominus

1. An insight into the personal dimension of the episode 2. Though Drew cast as victim in this piece, she clearly had no control over the London operation where the large derivative bets were placed 3. Two big issues: 1) The CIO was set up to take more risks than similar units in other banks, and 2) it had glaring deficiencies in its controls.

Default choice

1. An option that is selected automatically unless an alternative is specified 2. Madrian and Shea findings: First, 401(k) participation is significantly higher under automatic enrollment. Second, the default contribution rate and investment allocation chosen by the company under automatic enrollment has a strong influence on the savings behavior of 401(k) participants. A substantial fraction of 401(k) participants hired under automatic enrollment exhibit what we call "default" behavior--sticking to both the default contribution rate and the default fund allocation even though very few employees hired before automatic enrollment picked this particular outcome. This "default" behavior appears to result both from participant inertia and from many employees taking the default as investment advice on the part of the company. Overall, these results are consistent with the notion that large changes in savings behavior can be motivated simply by the "power of suggestion."

"JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses" by United States Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs

1. An update on recent developments 2. Authors conclude that that, over the course of the first quarter of 2012, JPM's CIO used its Synthetic Credit Portfolio (SCP) to 1) engage in high risk derivatives trading; 2) mismarked the SCP book to hide hundreds of millions of dollars of losses; 3) disregarded multiple internal indicators of increasing risk; 4)manipulated models; 5)dodged OCC oversight and 6) misinformed investors, regulators, and the public about the nature of its risky derivatives trading. 3. Investigation has exposed not only high risk activities and troubling misconduct at JPM, but also broader, systemic problems related to the valuation, risk analysis, disclosure, and oversight of synthetic credit derivatives held by U.S. financial institutions

Uncertainty in Practice

1. Analysts may still use subjective probabilities 2. But most often concerned with large, one of a kind shocks 3. Good risk management at least tries to incorporate uncertainty 4. Most risk management in finance and policy fails to do so (why worry about what one can't do anything about?) 5. Since prediction is not feasible, resiliency of institutions might become the focus

Systemically Important Financial Institutions (SIFIs)

1. Any firm as designated by the U.S. Federal Reserve, whose collapse would pose a serious risk to the economy. Systematically important financial institutions became the target of legislation and regulatory reform by the Obama Administration, due to issues concerning their consolidated supervision and regulation, following the financial crisis of 2008. 2. Economic risks can arise from the banking sector, but also from other financial organizations such as investment banks and insurance firms. New regulations under the Dodd-Frank legislation, mandate that financial institutions that fit SIFI qualifications, will have to meet higher capital standards and develop contingency plans for potential future failures. 3, Supervision and regulations of systemically important financial institutions is intended to prevent firms from becoming "too big to fail" and to prevent any assumptions that the government will provide financial support, in the event the firms do run into financial trouble. Many institutions have actively lobbied against being identified as a SIFI, because of the additional and significant regulatory requirements that SIFI firms will endure. 4. Factors for determining if a firm is a SIFI include size, if it accounts for a certain percentage of the activities of assets, of a financial sector or market, as well as contagion, correlation, concentration and conditions/context.

Loss Spiral

1. Arises for leveraged investors because a decline in the value of assets erodes the investors' net worth much faster than their gross worth (because of their leverage) and the amount that they can borrow falls. 2. This loss spiral arises as an equilibrium because some other potential buyers with expertise may face similar constraints at the same time and also because other potential buyers find it more profitable to wait out the loss spiral before reentering the market 3. In more extreme cases, other traders might even engage in "predatory trading," deliberately forcing others to liquidate their positions at fire-sale prices ("Deciphering the Liquidity and Credit Crunch 2007-2008" by Markus Brunnermeier)

Three influential theories of financial markets

1. Arrow-Debreu general equilibrium model 2. Mean-variance portfolio theory 3. (informationally) Efficient markets hypothesis

"Fussing and Fuming Over Fannie and Freddie: How Much Smoke, How Much Fire?" by W. Frame and Lawrence White

1. As an historical matter, Fannie Mae and Freddie Mac have surely enhanced the liquidity of mortgage loans, improved the geographic diversification of mortgage credit risk, and nationally integrated mortgage markets. 2. Further, the presence of Fannie Mae and Freddie Mac and their implied guarantees may well have been important for the innovation and development of mortgage securitization in the 1970s and 1980s. 3. Nevertheless, most of these benefits can now be achieved as a result of geographic deregulation of banking, which has allowed large, nationwide mortgage originators to emerge. 4. Mortgage securitization is now a well-established technology of finance that does not require the special status of Fannie Mae and Freddie Mac. 5. There seems no strong efficiency reason for preserving the existing structure of Fannie Mae and Freddie Mac. 6. They mostly just add to an already excessive encouragement for housing in the United States, using an implied guarantee that (to the extent that it would be honored) creates a contingent liability for the U.S. government. 7. Thus, a complete privatization of the two companies would be the first-best outcome. In this vision, the two companies would no longer enjoy any special privileges, but also would no longer be restricted to their current narrow slice of the financial world. The consequence of such a step for residential mortgage markets would be modest: Mortgage rates would probably rise by about 20-25 basis points (ceteris paribus). Because it appears that the United States already builds and consumes too much housing, this would be a move in the right direction. 8. Instead of backing a broad subsidy to housing through Fannie Mae and Freddie Mac, the federal government ought to focus on assisting first-time home buyers with low and moderate incomes 9. One useful step would be for government officials to state clearly, whenever the subject comes up, that the federal government does not guarantee the debt of Fannie Mae or Freddie Mac and will not bail them (or their creditors) out 10. Second, the enterprises should be forced to focus more on the lower end of the housing market. The loan limit for a conforming mortgage might be frozen at its current level of $359,650 for some years. The Department of Housing and Urban Development might strengthen the affordable housing goals that it sets for Fannie Mae and Freddie Mac. Indeed, in the fall 2004 HUD revised these goals in a way that should result in a marked increase in targeted lending. 11. Third, the safety-and-soundness regime should be strengthened so that it is more comparable to that of the federal banking agencies. This step should include giving OFHEO or its successor a) responsibility for the approval of new programs and other activities; b) the discretion to set both minimum and risk-based capital requirements; and c) receivership authority. While the presence of a safety-and soundness regulatory regime likely reinforces the market perception of an implied guarantee, stronger oversight should serve to reduce taxpayer exposure.

Dodd-Frank and LOLR Powers of the Fed

1. As consequence of seeing what was done as bailouts, Reserve Banks can no longer extend credit to an individual, partnership, or corporation other than through a "program with broad-based eligibility." 2. Such emergency facilities can only be created with prior approval of the Treasury Secretary and must be for the purposes of providing liquidity to the financial system and not to aid a failing financial company

"Overview and Operation of U.S. Financial Sanctions, Including the Example of Iran" by Barry Carter and Ryan Farha

1. As illustrated by the present U.S. sanctions against Iran, financial sanctions can prescribe rules for a wide range of activities by financial institutions and other persons and entities around the world. 2. Enforcement can be by a variety of measures where the United States has jurisdiction—for example, where the sanctioned entity might seek to undertake activities within the United States, because the sanctioned entity or its assets are within the United States, or because U.S. persons are involved in the activities.

The Cyclicality of Capital Ratios

1. As risk seemed to decline in booms, capital requirements were eased under Basel II 2. Closing the barn door behavior reinforces credit contractions

Mean variance analysis

1. Assumes economic agents maximize a utility function of mean return and variance (or standard deviation) of return in money terms 2. Implies a one period analysis 3. Requires probability distributions that have finite variances (no fat tails) and are normally distributed (unless utility has a special counter-intuitive form--quadratic) 4. Theoretical work in the 1950s has been exploited in increasing elaborate ways with growing computer power.

EU's Limits on Banker Compensation

1. Bonuses capped at 1 times annual comp with possibility of 2X with shareholder approval 2. Applies to all bank employees in the EU and to overseas (US) employees of EU institutions 3. UK has taken gone to European court to challenge 4. This years compensation round revealed imaginative evasions—pay in shares apparently doesn't count

Perfect or not, we have to have policy

1. Be concrete about what the problem is that is to be fixed (there are a lot of solutions out there looking for a problem): A) Don't try to fix everything, focus on where the stakes are clearly large, B) Consider a range of responses 2. Assess the unintended consequences: A) In the market, B) In the political dynamics that follow 3. Do cost benefit analysis that includes the unquantifiable and accounts for uncertainty in the outcome 4. Be attentive to time consistency 5. Try to minimize score settling 6. Be attentive to where tradeoffs are being made (between having expertise and creating conflicts of interest through revolving doors) 7. Don't think of policy as something that can be made and then forgot

Why worry about the safety and soundness of a single bank?

1. Before deposit insurance there was a consumer protection argument but supervision was lax 2. With the advent of deposit insurance, the insurance fund (and the government that backed it up) had a stake in controlling "moral hazard" 3. Insurance has implicitly and effectively extended to all liabilities of a bank and to nonbanks 4. And the availability of a lender of last resort can also give rise to moral hazard

"Survey of Behavioral Finance" by Nicholas Barberis and Richard Thaler

1. Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. 2. Twenty years ago, many financial economists thought that the Efficient Markets Hypothesis had to be true because of the forces of arbitrage. Now understand that this was a naive view, and that the limits to arbitrage can permit substantial mispricing. Also understood by most that the absence of a profitable investment strategy does not imply the absence of mispricing. Prices can be very wrong without creating profit opportunities. 3. The empirical literature repeatedly finds that the asset pricing anomalies are more pronounced in small and mid-cap stocks than in the large cap sector. It seems likely that this finding reflects limits to arbitrage: the costs of trading smaller stocks are higher, keeping many potential arbitrageurs uninterested. While this observation may be an obvious one, it has not found its way into formal models.

Aggressive Security

1. Beta greater than 1 2. Expected to earn higher rate of return than the market

Defensive Security

1. Beta less than 1 2. Expected to earn lower rate of return than the market

Is too big to fail a reason to limit the size of banks and other financial institutions to the point where any institution could be allowed to fail?

1. Big or small institutions should pay the value of the reduction in cost of funds resulting from deposit insurance: This would remove any artificial market bias in favor of risk taking in depository institutions 2. It is unrealistic to think that the needs of a modern economy could be met by community banks: And their record of failure is not encouraging—486 banks have been closed by the FDIC since 2007, almost all were small. 3. Protection extends beyond depository institutions as shown by Bear Stearns and AIG (but not Lehman): A) There is no substitute for risk supervision of large, systemic institutions, B) And there is a case for charging for the value of the implicit insurance or neutralizing it with regulatory costs (former would be more efficient, especially if it can be linked to actual risk taking) 4. Small institutions can be collectively systemic. Their idiosyncratic risk will be priced in the market, but they have just as big an incentive to take on risk that will be systemic and thus make it necessary to bail them out: A) Stress in Spain currently is from financial condition of relatively small depository institutions—Caxias that were consolidated into a "bad bank"--Bankia, B) The national champions—BBVA and Santander--continue to be strong despite some spillover from sovereign risk 5. A modern economy needs institutions that embody systemic risk. 6. The objective should be to have them pay for the benefits, not shrink them below efficient size and scope

Anti-money laundering

1. Blocking transfers of money emerged as a tool in war on drugs (first law 1970) 2. US succeeded in gaining broad international engagement: A) Financial Action Task Force established 1989, B) Covered in 2 UN Conventions 3. Extended to Terrorist financing in 2001

Decisions are made by people not companies

1. Boards 2. CEOs and other top executives 3. Traders, fund managers and their supervisors 4. Sales people (mortgage originators, securities sales) 5. Risk managers 6. Equity investors 7. Creditors

Fundamentals of Bond Pricing

1. Bond price higher, the greater the coupon payment attached to the bond 2. Bond price higher, the greater the maturity value of the bond 3. Price of bond more volatile with respect to change in interest rates, the longer the term to maturity of the bond

Mortgage-Backed Securities

1. Bonds that pool thousands of mortgages and pass homeowners' payments through to investors 2. Securitized mortgages are known as mortgage-backed securities (MBS) 3. Pass-throughs were a dramatic innovation in the secondary mortgage market. The whole-loan market, the buying and selling of mortgages, was relatively illiquid. This presented a risk to mortgage lenders who could find themselves unable to find buyers if they wanted to sell their loan portfolios both quickly and at an acceptable price. Holding the loans also meant exposure to the risk that rising interest rates could drive a lender's interest cost higher than its interest income. But trading whole loans meant a raft of details and paperwork that made the business relatively costly. MBS changed that. By combining similar loans into pools, the government agencies are able to pass the mortgage payments through to the certificate holders or investors. This change made the secondary mortgage market more attractive to investors and lenders alike. Investors now had a liquid instrument and lenders had the option to move any interest rate risk associated with mortgages off of their balance sheet. 4. ABS and MBS represent an interest in the underlying pools of loans or other financial assets securitized by issuers who often also originate the assets. The fundamental goal of all securitization transactions is to isolate the financial assets supporting payments on the ABS and MBS. Isolation ensures payments associated with the securities are derived solely from the segregated pool of assets and not from the originator of the assets. By contrast, interest and principal payments on unsecuritized debt are often backed by the ability of the issuing company to generate sufficient cash to make the payments.

Basis risk

1. Breakdown of negative correlation 2. The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other 3. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position

Multiple interests may shape policy

1. Broad public interest in efficient financial intermediation 2. Client interest 3. Competitor interest 4. Government (taxpayer) interest Will talk about how size and scope of activities affect these interests. The FSOC Chairman's Report in this week's readings is an unusually good overview of policy issues and research that is relevant to them

Channels of shareholder influence

1. Buy and sell: Shareholder voting with their feet is most effective in focusing management receiving incentive comp 2. Market for corporate control: A) Threat of takeover provides incentives for management to perform and keep stock price up, B) Effectiveness in finance undercut by regulatory restrictions and approval processes on takeovers 3. Shareholder votes: A) Rarely effective in opposing management—organizational costs can be high, B) Treated as a nuisance

Legacy of CDS

1. CDSs continue to be under a cloud after the financial crisis 2. Their utility as a risk management tool has been established 3. While market is smaller than before the crisis, it is still substantial 4. CDSs are likely to continue as a risk management and risk positioning tool.

Policy Concern 1: Misuse of information across business lines

1. Can be dealt with in many cases by erecting "Chinese Walls": A) Securities origination and sales and trading, B) This may remove the only potential synergy, C) Asset management and origination 2. Sometimes the synergy is real but still raises political issues: Losing party may be competitors and not customers (restrictions on linking of bank loans and investment banking services) 3. Potential for uncontrollable abuse would be a reason to ban businesses from combining activities: A) Specific abuses should be identified before curbing the market, B) Many (Shafer included) support separation of banking and commerce on these grounds

Assessment of FCPA

1. Can see results in punishment, deterrence and incentivizing change 2. Has had an impact on illicit payments by firms based in developed countries 3. Enforcement beginning to expand into emerging markets 4. Multilateralization has been critical to success Costs have not got out of hand; but compliance issues are becoming more complex

Potential social benefits of large financial firms

1. Capacity to deliver services nationally or globally: A) Of value to large or global firms, B) Also of value to internationally mobile individuals 2. Capacity to provide a full range of financial services: A) Can support a firm's fund raising needs with loans, bonds and equity, B) Can provide risk management products (derivatives) alongside financing 3. National champions 4. Potential efficiency gains in IT and other functions with economies of scale

Benefits of Size (2)

1. Capacity to serve customers that are large or have geographically spread businesses 2. Capacity to diversify risks 3.Too big to fail: benefit from creditors and credit ratings agencies found in econometric research—a benefit to the firm but not to society 4. Is there a benefit of curbing scale because it exceeds optimal, taking account of these benefits? 5. How reliably do we know what is optimal? 6. Will it remain fixed? 7. Won't the market punish excessive scale? 8. Alternative would be to neutralize artificial incentives to grow 9. Or fix governance failures that allow growth that hurt equity holders

The CAMEL(S) Approach

1. Capital adequacy 2. Asset quality: a) performing, special mention, substandard, doubtful, loss, b) concentration (company, industry, country), c) Insider loans or connected lending 3. Management 4. Earnings quality-stable earnings from core activities, not reliance on extraordinary items, securities transactions, high risk activities... 5. Liquidity (has received greater attention post crisis) 6. (Sensitivity to market risk) Note: A dialog with senior management can potentially compensate for weaknesses in management and risk structure if it is not adversarial

When LOLR may not be effective

1. Capital requirements may override use of liquidity (e.g. regulatory, market driven) 2. Can throw good money after bad in defending an indefensible exchange rate even if the country is solvent in a long term cash flow potential sense (Euro area?)

"The Credit Crisis: Conjectures about Causes and Remedies" by Douglas Diamond and Raghuram Rajan

1. Causes of crisis: global savings imbalance, easy monetary policy, "originate-to-securitize" process, incentives at the top, flawed internal compensation and control, rise in short-term debt 2. Crisis Trigger: falling house prices 3. In depth of crisis, banks unwilling to lend 4. To ease credit, government can 1) buy illiquid assets, 2) recapitalize institutions that probably will survive or 3) do both

Regulatory Response to Junk Bonds

1. Close surveillance of market practices of Drexel from the beginning culminated in insider trading case 2. Concern that Savings and Loans had overinvested in junk bonds (only a handful in California and Texas had significant holdings) led Congress to force divestiture by S&Ls 3. Market not restricted despite outcry over risk, involvement in LBOs and Milken's crimes

Proprietary trading and banking (the Volcker Rule)

1. Commercial considerations have led managers of large firms to seek to limit prop trading without regulatory pressure: A) Sandy Weill closed down the proprietary trading desk after acquiring Salomon Brothers for Travelers, B) Salomon Brothers and others that derived substantial earnings from proprietary desks have always had their equity trade at a discount 2. Concentrated risks still arise in banks, but not often on prop books: A) Citi exposures not supported by most senior management, B) Russia 2008, C) Argentina 2001, D) Subprime super senior tranches 2007(?), D) JP Morgan whale trade 3. More effective supervision might reduce these risks, but ex ante business restrictions are likely to fail and could carry costs in restricting business in the wrong way Shafer would bet that 20 years from now the Volcker Rule will be greatly eroded if not repealed (Glass Steagall lasted nearly 70 years, but there were strong protected interests within the industry)

Rating Agencies

1. Companies that assess the creditworthiness of both debt securities and their issuers. In the United States, the three primary bond rating agencies are Standard and Poor's, Moody's and Fitch. Each uses a unique letter-based rating system to quickly convey to investors whether a bond carries a low or high default risk and whether the issuer is financially stable. 2. Bonds are rated at the time they are issued, and both bonds and their issuers are periodically reevaluated to see if a ratings change is warranted. Bond ratings are important not only for their role in informing investors, but also because they affect the interest rate that companies and government agencies pay on their issued bonds. 3. For example, Standard and Poor's highest rating is AAA - once a bond falls to BB+ status, it is no longer considered investment grade, and the lowest rating, D, indicates that the bond is in default (the issuer is delinquent in making interest and principal payments to bondholders). 4. Since the 2008 financial crisis, ratings agencies have been criticized for not identifying all of the risks that could impact a security's creditworthiness, particularly in regard to mortgage-backed securities that received high credit ratings but turned out to be high-risk investments. 5. Investors are also concerned about a possible conflict of interest between the rating agencies and the bond issuers, since the issuers pay the agencies for the service of providing ratings. Because of these and other shortcomings, ratings should not be the only factor investors rely on in assessing the risk of a particular bond investment.

Policies to limit or reshape compensation in the United States before the crisis

1. Compensation has long been a part of the bank supervisory discussion but regulators have not taken a tough line 2. The 1993 Tax and Budget Act capped executive pay at $1 million unless recipients met specified performance goals: Average CEO pay rose about 150% over the next 10 years (average pay of all employees rose 40%) 3. Sarbanes Oxley (2002) restricted loans to officers and some compensation practices for all industries but did not limit compensation

"Crisis and Panic" by FCIC

1. Concludes that, as massive losses spread throughout the financial system in the fall of 2008, many institutions failed, or would have failed but for government bailouts 2. As panic gripped the market, credit markets seized up, trading ground to a halt, and the stock market plunged 3. Lack of transparency contributed greatly to the crisis: the exposures of financial institutions to risky mortgage assets and other potential losses were unknown to market participants, and indeed many firms did not know their own exposures 4. The scale and nature of the over-the-counter (OTC) derivatives market created significant systemic risk throughout the financial system and helped fuel the panic in the fall of 2008: millions of contracts in this opaque and deregulated market created interconnections among a vast web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults 5. A series of actions, inactions, and misjudgments left the country with stark and painful alternatives—either risk the total collapse of our financial system or spend trillions of taxpayer dollars to stabilize the system and prevent catastrophic damage to the econom

"March 2008: The Fall of Bear Stearns" by FCIC

1. Concludes the failure of Bear Stearns and its resulting government-assisted rescue were caused by its exposure to risky mortgage assets, its reliance on short-term funding, and its high leverage 2. These were a result of weak corporate governance and risk management: its executive and employee compensation system was based largely on return on equity, creating incentives to use excessive leverage and to focus on short-term gains such as annual growth goals 3. Bear experienced runs by repo lenders, hedge fund customers, and derivatives counterparties and was rescued by a government-assisted purchase by JP Morgan because the government considered it too interconnected to fail 4. Bear's failure was in part a result of inadequate supervision by the SEC, which did not restrict its risky activities and which allowed undue leverage and insufficient liquidity

Alpha of an asset

1. Constant factor in CAPM that varies between securities 2. αi is the yield of the security adjusted for risk (equilibrium value would be the risk free rate)

Are there reasons for supervision of individual banks or other financial institutions other than moral hazard?

1. Consumer protection in the absence of insurance? 2. Reduce systemic risk? 3. Compensate for Governance failure? (Could be applied to any sector; are financial institutions special?) 4. Should public policy seek to reduce risk below level chosen by a financial institutions management and sophisticated customers? Is there a role for self-regulation here?

Problems with CAPM

1. Correlations as well as standard deviations do change (unfortunately in times of stress correlations tend towards one—risk becomes undiversifiable) 2. Response to changing risk has too often been to focus only on the recent past 3. Use has led analysts to focus on the repeated events that fit a normal distribution at the expense of looking at fat tail or low frequency extreme events (how often should one see 4σ events?) 4. Its use increased complacency about risk during the "Great Moderation" 5. But there is no other comparably powerful tool

Governments intervene in financial markets in pursuit of a range of objectives unrelated to finance and even to economics

1. Countering drug trafficking and other crime--Anti Money Laundering (AML) 2. Disrupting terrorist financing--Title III of the Patriot Act 3. Stopping bribery of foreign government officials--Foreign Corrupt Practices Act (FCPA) 4. Furthering social policy goals--Community development 5. Furthering foreign policy goals--Sanctions legislation

IMF, OECD Convention on Combatting Bribery of Foreign Public Officials in International Business Transactions

1. Countries required to make Bribery of foreign public officials a criminal offense 2. Sanctions defined as "effective, proportionate and dissuasive criminal penalties" comparable to those applicable to the bribery of the country's own officials 3. Bribery defined as the offering or paying of bribes, not soliciting or receiving of bribes 4. Norms of the Convention are not self-executing: require reformulation by each country

Citigroup

1. Date: November 2009 2. Trigger: Citi's fall would've endangered financial stability 3. Actions: Loss limitation put on Citi's losses. Put a ring fence around Citi's assets. Fed and Treasury responsible for 90% of losses above level that Citi was shouldering 4. Results: Greater financial stability

Sales of Treasury bonds matched by purchases of agency (Fannie Mae or FreddieMac) guaranteed bonds

1. Date: November 2009 2. Trigger: Mortgage interest rates rising 3. Actions: These programs were introduced with the explicit aim of reducing mortgage interest rates 4. Results: Mortgage interest rates dropped

Creative destruction

1. Creative destruction: A term coined by Joseph Schumpeter to denote a "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." 2. Its cycle is as follows. 1. A new way of doing business: A) Creates super normal profits for the innovator, B) Destroys profits of competing firms doing things the old way 2. Innovation is imitated: A) Supernormal profits are eroded by increased competition from imitators, B) Patents, copyrights and secrecy may slow the rise of competition, but it rarely, if ever, stops it 3. Drive for new innovation to sustain profits: A) May take the form of building more risk into the new process—heightened risk of distress, B) Incumbents may undertake change that can also create risk 4. May lead to new innovations that start the cycle over 5. But innovations usually outlive the conditions that created them once they are firmly established (money market mutual funds)

Credit Enhancement

1. Credit enhancement is common in securitization transactions. 2. Depending on the nature of the transaction and the type of assets, the securitization pool may need such support to attract investors. 3. Enhancement or support can come from the assets themselves or from an external source. Examples of internal enhancements include subordinating one or more tranche, or portion, of the securities issued. 4. This practice places the claims of one tranche over another. 5. Any defaults affecting the securities must be absorbed by a subordinate tranche before the senior tranche is affected. 6. Over-collateralization of asset pools is also used to enhance credit. 7. This occurs when the amount of assets placed in a securitization pool exceeds the principal amount of bonds issued. 8. External credit enhancements can include a surety bond or a letter of credit from a financial institution. 9. Both options serve as guarantees that investors will receive the payments associated with the securities. GSEs enhance the credit of the MBS they issue by guaranteeing the timely repayment of principal and interest.

Market Infrastructure and Systemic Risk

1. Credit ratings and how they are used 2. Clearing and settlement

Portfolio Theory

1. Crucial insight: as long as returns on securities not perfectly correlated, there is gain to be had through diversification 2. Problem, however, is the enormous number of covariances that have to be calculated when assessing the risk to a portfolio

Discount window actions

1. Date: August 2007 2. Trigger: Signs of illiquidity in financial markets 3. Actions: Lowered discount rate 4. Results: Financial institutions had slightly easier time accessing liquidity

Quantitative easing programs

1. Date: Beyond 2009 2. Trigger: Economy in the doldrums 3. Actions: Fed bought up assets like long-term Treasuries or mortgage-backed securities from commercial banks and other institutions to pump money into the U.S. economy and reduce long-term interest rates further 4. Results: Seems to have worked

TAF

1. Date: December 2007 2. Trigger: Amid widespread concerns about the condition of many financial institutions, investors became very reluctant to lend, especially at maturities beyond the very shortest terms 3. Actions: Fed created Term Auction Facility (TAF) under which it auctioned 28-day loans, and, beginning in August 2008, 84-day loans, to depository institutions in generally sound financial condition 4. Results: eliminated stigma and gave Fed control over timing and amount of liquidity injected into market

Central Bank Liquidity Swaps

1. Date: December 2007 2. Trigger: Because of the role that the US dollar plays in global financial markets, strains in dollar funding markets overseas can disrupt financial conditions in the US 3. Actions: To address severe strains in global short-term dollar funding markets, the Federal Reserve established temporary central bank liquidity swap lines with a number of foreign central banks: foreign central banks then could draw on those lines to provide dollar liquidity to institutions in their jurisdiction 4. Results: programs helped lower the liquidity premium in interbank rates by as much as 70 bps

Bank of America

1. Date: January 2009 2. Trigger: Prevent meltdown 3. Actions: Fed, Treasury and FDIC invested $20 billion in Bank of America and guarantee $118 billion of assets "as part of its commitment to support financial-market stability," 4. Results: Financial stability

Maiden Lane

1. Date: March 2008 2. Trigger: Bear Stearns about to fall and JPM didn't want to risk taking its toxic mortgage assets 3. Actions: FRBNY created Maiden Lane to hold $30 bn worth of those toxic assets: JPM on hook for first bn, after that on FRBNY 4. Results: By averting the failure of an extraordinarily connected company, the Federal Reserve through Maiden Lane had averted a meltdown

Single Tranche Open Market Operations

1. Date: March 2008 2. Trigger: Heightened stress in funding markets 3. Actions: Auctioned liquidity to primary dealers for any of the types of securities: Treasuries, agency debt, or agency MBS 4. Results: By providing term funding to primary dealers, this program helped to address liquidity pressures evident across a number of financing markets and supported the flow of credit to U.S. households and business

TSLF

1. Date: March 2008 2. Trigger: Primary dealers often obtain funding by pledging securities as collateral. When the markets for the collateral became illiquid, primary dealers had increased difficulty obtaining funding and, therefore, were less able to support broader markets 3. Actions: the Federal Reserve loaned relatively liquid Treasury securities for a fee to primary dealers for one month in exchange for eligible collateral consisting of other, less liquid securities: loans made through auctions 4. Results: the TSLF supported the liquidity of primary dealers and fostered improved conditions in financial markets more generally 5. Name: Term Securities Lending Facility

PDCF

1. Date: March 2008 2. Trigger: Severe strains in the triparty repurchase agreement market and the resulting liquidity pressures faced by primary dealers 3. Actions: The extension of discount window lending to primary dealers 4. Results: the cost of insuring dealers declined and the fact that dealers used it so frequently gives reason to believe that the PDCF helped alleviate the short-term funding problems that would have been even worse otherwise 5. Name: Primary Dealer Credit Facility

TALF

1. Date: November 2009 2. Trigger: ABS markets became severely disrupted during the financial crisis in 2008, drastically reducing the supply of credit to consumers and businesses 3. Actions: Fed issued nonrecourse loans with a term of up to five years to holders of eligible ABS 4. Results: Still being paid off on schedule 6. Name: Term Asset-Backed Securities Loan Facility

CPFF

1. Date: October 2008 2. Trigger: In the fall of 2008, the commercial paper market was under considerable strain as money market mutual funds and other investors--themselves often facing liquidity pressures--became increasingly reluctant to purchase commercial paper. The volume of outstanding commercial paper fell, interest rates on longer-term commercial paper increased significantly, and an increasingly high percentage of outstanding commercial paper needed to be refinanced each day. This restriction in the availability of credit made it more difficult for businesses to obtain credit during a critical period of economic stress 3. Actions: FRBNY provided three-month loans to the CPFF LLC, a specially created limited liability company (LLC) that used the funds to purchase commercial paper directly from eligible issuers 4. Results: By providing liquidity to the commercial paper market, the CPFF encouraged investors to resume lending in the market 5. Name: Commercial Paper Funding Facility

MMIFF

1. Date: October 2008 2. Trigger: MMMFs needed liquidity to increase their ability to meet redemption requests and MMMF investors needed to be more willing to invest in money market instruments 3. Actions: Provided liquidity 4. Results: Strengthened CP market 5. Name: Money Market Investor Funding Facility

AMLF

1. Date: September 2008 2. Trigger: Reserve Primary Fund, MMMF with small share of Lehman CP, forced to break the buck 3. Actions: Fed made loans to depository institutions to buy CP 4. Results: Though the Fed eventually created other programs to stem the collapse of the CP market and MMMFs, the AMLF was instrumental as a first-line of a defense against a run on MMMFs: the MMMFs that experienced greater decreases in outflows held greater amounts of collateral deemed eligible under the AMLF 5. Name: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

AIG loans

1. Date: September 2008 2. Trigger: The potential failure of AIG during the financial crisis posed significant systemic risks. Banks and others had exposure to it: default on its CP would've shaken entire market. 3. Actions: The revolving credit facility was established to assist AIG in meeting its obligations as they came due and to facilitate a process under which AIG would sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy 4. Results: Saved world from even worse meltdown

The innovation of Eurodollars

1. Deposits of foreigners denominated in dollars in a bank outside the US and loans made outside the US with these funds 2. Two defining features: A) Denomination of deposits and loans not the currency of the country where the bank office is located, B) Depositor or lender is not a resident of the country where the bank is located

"The Market for 'Lemons': Quality Uncertainty and the Market Mechanism" by George Akerlof

1. Discusses economic models in which "trust" is important. 2. Informal unwritten guarantees are preconditions for trade and production. Where these guarantees are indefinite, business will suffer -as indicated by our generalized Gresham's law. 3. This aspect of uncertainty has been explored by game theorists ,as in the Prisoner's Dilemma, but usually it has not been incorporated in the more traditional Arrow-Debreu approach to uncertainty. 4. But the difficulty of distinguishing good quality from bad is inherent in the business world; this may indeed explain many economic institutions and may in fact be one of the more important aspects of uncertainty.

"Financial Stability Monitoring" by Adrian, Covitz, and Liang

1. Dodd Frank Act (DFA) does not address some important risks that could migrate to or emanate from entities outside the federal safety net 2. At the same time, DFA limits the types of interventions by financial authorities to address systemic events when they occur 3. As a result, a broad and forward-looking monitoring program, which seeks to identify financial vulnerabilities and guide the development of pre-emptive policies to help mitigate them, is essential 4. Systemic vulnerabilities arise from market failures that can lead to excessive leverage, maturity transformation, interconnectedness, and complexity 5. These vulnerabilities, when hit by adverse shocks, can lead to fire sale dynamics, negative feedback loops, and inefficient contractions in the supply of credit

Current status of US size policy

1. Dodd Frank imposes a 10% market share cap on consolidated liabilities (measured on a risk weighted assets basis) of financial institutions when a merger occurs 2. Does not restrict organic growth 3. Complements a 10% deposit cap in Reigle Neal (also only at the time of a merger) Experience of Citibank suggests organic growth is difficult so merger restrictions may be what matter

Why insurance of brokerage accounts differs from deposit insurance

1. Does not protect against loss of value on investments 2. Provides protection against misappropriation of assets left with the broker-dealer 3. US SIPC provides up to $500,000 to cover losses in brokerage accounts—a third line of defense 5. The first line of defense is required segregation of customer assets and their removal from the bankruptcy process (failed in bankruptcy of commodities broker MF Global) 6. Second line of defense is recovery value of the firm alongside other creditors

Effects of Dodd Frank and Riegle Neal on US market is ambiguous

1. Doesn't cut on the relevant local or regional market concentration in most cases 2. Will prevent dominance of the US market by a small number of firms (but so would Sherman Act) 3. Could limit threat of takeover incentive to be efficient among smaller banks 4. Could incentivize good business practices to build market share through organic growth 5. Could disadvantage US banks relative to much larger foreign banks 6. Does keep US institutions below a dangerous threshold of taxpayer exposure to risk 7. Does not preclude effective risk diversification 8. Largest US banks (near the limit) seem, on average, not to be better or worse managed than smaller banks on average (a lot to criticize in both groups) 9. Political power of largest banks grew before crisis and has held up in the back rooms, but so has power of organized smaller banks. Issue, if there is one, seems more to be the role of money in politics than the role of size in financial institutions.

Legacy of Eurodollars

1. Dollar liabilities of banks outside the US were $7.5 trillion in September last year ($1 trillion to non-banks, remainder interbank) 2. LIBOR (London interbank offer rate) the global standard for dollar interest rates, including for US ARM mortgages 3. Banking has developed in euro and other currencies in London and elsewhere 4. Eurodollar and other international bond markets have become important

External Change Leading to Innovation

1. Technology (ATM) 2. Changing market conditions (high interest rates in the 1970s gave rise to money market mutual funds) 3. Changing regulatory conditions or taxes (Structured Investment Vehicles (SIVs) to avoid Basel capital requirements)

Key CAPM Equation

1. E(Ri) = ai + BiE(Rm) + ei 2. Ri and Rm are the returns on the security and the market portfolio 3. βi is the responsiveness of the security to the market 4. αi is the yield of the security adjusted for risk (equilibrium value would be the risk free rate) 5. ei is the random unpredictable component of the return on the security independent of the market

Foreign initiatives to limit executive compensation

1. EU adopted last year limits on banker compensation 2. Switzerland on March 1, 2013 passed referendum on pay for all sectors (68% vote in favor): A) Shareholder "say on pay", B) No bonuses on arrival, departure or merger 3. Switzerland in November 2013 rejected a cap on pay of 12 times the pay of the lowest wage employee 4. What will future trends and effects be: On overall compensation? On risk taking incentives? On the structure and location of the financial services industry?

Assessment of Anti-money laundering

1. Effectiveness subject to doubt: A) Drug flows appear unabated, B) Terrorism not intensely money dependent, C) But intelligence can be gained (sometimes bad intelligence) from the apparatus, D) And there are some significant catches (of money, not often of important people) 2. Imposes very heavy compliance burden 3. Requires intrusiveness and invasions of privacy 4. Can inhibit innovation: A) PayPal almost derailed, B) BitCoin under threat

What is moral hazard and how would it affect the capital decisions of bank managements and the interests of shareholders?

1. Equity is limited-liability: you get upside, if business good and banks are way more levered than any other business 2.Deposit insurance: creditors who are protected aren't imposing any discipline and the limited liability mean stakeholders don't care about downside, unless certain amount of money in game People think banks need more capital to internalize externality

Federal Insurance Office

1. Established by Dodd-Frank in the Treasury 2. Has the authority to monitor all aspects of the insurance sector, monitor the extent to which traditionally underserved communities and consumers have access to affordable non-health insurance products, and to represent the United States on prudential aspects of international insurance matters, including at the International Association of Insurance Supervisors 3. In addition, FIO serves as an advisory member of the Financial Stability Oversight Council, assists the Secretary with administration of the Terrorism Risk Insurance Program, and advises the Secretary on important national and international insurance matters

Consumer Financial Protection Bureau (CFPB)

1. Established by Dodd-Frank within the Federal Reserve but functionally independent 2. Responsible for consumer protection in the financial sector 3. Its jurisdiction includes banks, credit unions, securities firms, payday lenders, mortgage-servicing operations, foreclosure relief services, debt collectors and other financial companies operating in the United States

Four case studies

1. Eurodollars—driven by regulatory conditions 2. Junk bonds—driven by market conditions 3. Credit Default Swap—multiple drivers 4. The S&L Industry—a failure to innovate

What is the role of market discipline in supervision and regulation?

1. Even if creditors are not carefully assessing risks because of moral hazard, equity owners should be 2. But the record isn't good—banks were selling at 2X book at the beginning of 2007 and being conservative carried a discount 3. Complexity is a barrier to outside discipline 4. Regulation restrains the market in corporate control 5. But regulators and shareholders should see each other as partners in focusing banks on risk adjusted returns 6. Policy might work to make market discipline more effective rather than less so. How?

Creditor incentives

1. Even if interests are aligned with shareholders, managers are sensitive to credit cost 2. Short term depositors and lenders will vote with their feet—unfortunately not a timely discipline 3. Long term bond yields can be effective if A) No moral hazard from prospective government support, B) Disclosure is adequate, C) Analysts have market aligned incentives: credit rating agencies, fixed income investment analysts

Why nearly or usually efficient markets can fall far short of optimality

1. Excess volatility 2. Long delayed corrections with near random walk 3. Exercise of market power by a large investor or group of investors

Innovation frequently leads to new risks or potential for abusive practices

1. Failure of policy to respond can allow risks and abuses to grow 2. In an uncertain environment with multiple policy objectives, first response is often not the best and the innovators are likely to adapt to policy changes—need for an iterative response (electronic stock trading).

Fannie Mae: Crowded Revolving Door

1. Fannie Mae was a leading advocate of the loose-lending policies that led to the Great Recession of 2008. 2. Thanks to its implicit government guarantee, Fannie Mae aggressively promoted the sub-prime mortgages that resulted, especially in its relationship with the now-bankrupt Countrywide Financial. 3. The present and former Democratic presidential administrations were filled with former and future Fannie Mae officers and employees.

What effects did Basel I and II have on shadow banking? What do you expect the effect of Basel III to be?

1. Fed crowding into AAA synthetic instruments 2. Also led banks to create SIVs, so it owns risky assets 3. SIVs relied on ABCP and came back on balance sheet during crisis 4. Existing SIVs have to be counted on balance sheets now.

"JPMorgan Tracked Business Linked to China Hiring" by Ben Protess and Jessica Silver-Greenberg

1. Federal authorities have obtained confidential documents that shed new light on JPMorgan Chase's decision to hire the children of China's ruling elite, securing emails that show how the bank linked one prominent hire to "existing and potential business opportunities" from a Chinese government-run company. 2. The documents, which also include spreadsheets that list the bank's "track record" for converting hires into business deals, offer the most detailed account yet of JPMorgan's "Sons and Daughters"hiring program, which has been at the center of a federal bribery investigation for months. The spreadsheets and emails — recently submitted by JPMorgan to authorities — illuminate how the bank created the program to prevent questionable hiring practices but ultimately viewed it as a gateway to doing business with state-owned companies in China, which commonly issue stock with the help of Wall Street banks. 3. The hiring practices seemed to have been an open secret at the bank's headquarters in Hong Kong, according to the documents, copies of which were reviewed by The New York Times. In the email citing the "existing and potential business opportunities," a senior JPMorgan executive in Hong Kong emphasized that the father of a job candidate was the chairman of the China Everbright Group, a state-controlled financial conglomerate. The executive also extolled the broader benefits of the hiring program, telling colleagues in another email: "You all know I have always been a big believer of the Sons and Daughters program — it almost has a linear relationship" with winning assignments to advise Chinese companies. Until now, the indications of a connection between the hires and business deals have not been so explicit.

"Financial Innovation" by Paul Tufano

1. Financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies,institutions and markets. 2. While there seems to be some agreement that the best categorization scheme [for financial innovation] is a functional one, it is less clear how to identify the particular functions. 3. Theories to explain innovation: A) Innovation exists to complete inherently incomplete markets, B) Innovation persists to address inherent agency concerns and information asymmetries, C) Innovation exists so parties can minimize transaction, search or marketing costs, D) Innovation is a response to taxes and regulation, E) Increasing globalization and risk motivate innovation, F) Technological shocks stimulate innovation 4. No one theory works to explain innovation 5. At least for securities innovations, larger, more financially secure investment banks have consistently been the leading innovators. There might be a self-reinforcing cycle between innovation and market share, with larger firms innovating and thereby increasing their size at the expense of their rivals. 6. Among issuers, it is difficult to argue that the most constrained firms are the most innovative. Rather, a great deal of innovation is directed at larger, well-established firms 7. Perhaps, smaller and weaker firms face a great number of constraints, and their efforts are focused on addressing these constraints directly rather than optimizing the form of capital. Larger firms may have addressed these first-order imperfections and turn their attention to more nuanced capital structuring issues and innovations 8. In many of these studies, it has been the larger firms that have innovated more rapidly, for example, with larger banks more quick to adopt credit scoring or larger investment banks are faster to underwrite new securities

History of Eurodollars

1. First deposit was in Moscow Narodny Bank in London in 1957 2. Developed to provide the full range of corporate banking services in dollars outside the US 3. Spread from London to other financial centers: Luxemburg, Nassau, Hong Kong,... 4. Spread from dollars to other currencies: euro yen, euro marks and now euro euros 5. Bank liabilities to foreigners denominated in a foreign currency reported to the BIS in September last year totaled $12 trillion (about 2/3 dollars).

History of CDOs

1. First done by Drexel Burnham Lambert for a savings bank in 1987 2, Picked up and developed by JP Morgan to clean up its loan portfolio in 1994 3. Development supported by innovations in analytical techniques—Gaussian Copula developed by David Li at JP Morgan in 2001 4. Tranching adopted by securitizers of mortages in the 2000s 5. Grew rapidly to over $500 billion in new issuance in 2006 6. Market blew up in 2007, prices collapsed and issuance virtually ceased

"Reflections on Glass-Steagall and Maniacal Deregulation" by Robert Weissman

1. First, Glass-Steagall's key insight was in the need to treat regulation from an industry structure point of view. Glass-Steagall's authors did not set out to establish a regulatory system to oversee companies that combined commercial banking and investment banking. They simply banned the combination of these enterprises. Cleaning up the current mess, we need strategies that focus on industry structure -- meaning, especially, that we must break up the big banks -- as well as more traditional regulation. 2. Second, we need to return to Glass-Steagall's more particular understanding: depository institutions backed by federal insurance protection cannot be involved in the risky, speculative betting of the investment banking world. (Notably, the Glass-Steagall problem is now worse than it was before the financial crisis, following JP Morgan's acquisition of Bear Stearns, and Bank of America's takeover of Merrill Lynch.) Moreover, we need not just to reinstate Glass-Steagall, but infuse its underlying principles throughout the financial regulatory scheme. Commercial banks should not be in the business of speculation. They have a job to do in providing credit to the real economy. They should do that. Their job is not to engage in betting on derivatives and other exotic financial instruments. 3. Third, giant financial institutions exercise too much political power, and for that reason alone must be broken up. 4. Fourth, we need broad reform in the area of money and politics. We need public financing of Congressional regulations, even stronger lobbyist reforms, and tight restrictions to close the revolving door through which individuals spin as they travel between positions in government and industry.

Walter Wriston, the CEO of Citicorp, said in the 1970s that banks didn't need capital. Why did regulators take a different view in the 1980s?

1. Had low bank capital standards in 1980s 2. Came out of events in 1970s. US strongly believed there should be capital standards 3. In 1980s, foreign banks played large role in US market 4. US regulators said that because foreign banks didn't have capital standards, there should be a level playing field 5. Latin American crisis in 1982-1983: galvanized push for capital standards 5. Central banks created standards: Basel standards have no legal force.

"The Fundamental Principles of Financial Regulation" by Brunnermeier, Crockett, Goodhart, Persaud and Shin

1. Focus on systemic risk 2. We need to supplement micro-prudential regulation with macro-prudential regulation to calm the booms and soften the busts 3. Financial institutions could complement mark-to-market accounting with mark-to-funding valuations, which would be more appropriate for assessing risk and capital adequacy 4. Regulation should acknowledge that some banks are systemically important and the others are less so: supervisors should determine, (but not publicise), which are the systemically-important institutions that need closer scrutiny and greater control 5. Recommend a switch back from "home country" regulation towards host country regulation to 1) reduce exposure to lax jurisdictions and 2) allow for differentiated response to asset boom 6. In nutshell, the previous focus on micro-prudential regulation needs to be supplemented by macro-prudential regulation

Less draconian official responses than resolution

1. Forbearance—the traditional approach: a postponement of loan payments, granted by a lender or creditor, for a temporary period of time, done to give the borrower time to make up for overdue payments 2. Prompt corrective action--Federal Deposit Insurance Corporation Improvement Act of 1991 took away discretion

History of Savings and Loan (S&L) Industry

1. Forerunners going back to early days in the US 2. Financial distress and price declines in the 1930s led to massive home foreclosures and the creation of a policy infrastructure for S&Ls with fixed rate long amortizing mortgages the only instrument 3. The industry came under pressure beginning in the 1960s from rising and volatile interest rates: A) Deposits were short term, B) Loans were long term 4. Repeated successful efforts to get support through policy failed to save industry: A) 1966--50 bp legislated premium over bank interest rate on savings deposits, B) 1968, 1970 creation and then privatization of Fannie and creation of Freddie to buy and securitize mortgages 5. Industry went into deep distress in 1980 when high interest rates lowered value of mortgage assets and created a deposit drain: A) 1980 Deposit Institutions Deregulatory and Monetary Control Act got rid of untenable interest rate ceilings and gave S&Ls power to make consumer and business loans, B) 1982 St. Germain Depository Institutions Act allowed ARMs and further broadened lending powers 6. S&Ls with impaired capital used new powers to bet the bank with deposit insurance protection: Clean up of S&L crisis of the late 1980s cost taxpayers $125 billion

Fannie Mae: What happened?

1. Founded as a government agency in 1938 to raise money for mortgage lenders 2. Partly privatized in 1954 and then totally privatized (but with partial government guarantee and continuing policy mission in 1968) to take debt of the federal budget during the Vietnam war 3. Came to dominate mortgage markets in the 1980s after collapse of S&Ls supported by perceptions of government backing beyond what is in the law 4. Policy mission intensified in the 1990s 5. Became a career stop for enrichment of government officials 6. Developed the most elaborate lobbying organization in corporate America 7. 2004 accounting fraud revealed 8. 2008 taken into conservatorship and creditors protected—validating the belief in implicit support 9. 2011 former officers charged with securities fraud 10. Government says it wants to wind down but its dominance of mortgage financing is greater than ever

"The lender of Last Resort: Alternative Views and Historical Experience" by Michael Bordo

1. Four views on the proper role of the lender of last resort: classical, G and K, G, free banking 2. The Classical View: the LLR should provide whatever funds are needed to allay a panic 3. Goodfriend and King: an open market operation is the only policy required to stem a liquidity crisis 4. Goodhart (and others): the LLR should assist illiquid and insolvent banks 5. Free Banking: no government authority is needed to serve as LLR. 6. The historical record for a number of countries suggests that monetary authorities following the classical precepts of Thornton and Bagehot can prevent banking panics.

Compliance with Anti-money laundering

1. Fundamental requirement is to "know your customer" (KYC) 2. Transactions over $10,000 or structured to avoid this must be reported 3. Suspicious transactions must be blocked 4. Special provisions for senior government officials (in the interest of anti-corruption)

Sources of failure relative to public interest ideal: Complex interactions

1. Gaming the regulator: Basel implementation 2. Time inconsistency: A) Moral hazard from implicit support (to big to fail), B) Adverse selection (retirement saving decisions) Governments behave in time inconsistent ways every day and yet politicians and officials are amazed that they are not believed.

"Policy Watch: The Repeal of Glass-Steagall and the Advent of Broad Banking" by James Barth, Dan Brumbach, and James Wilcox

1. Glass-Steagall lasted more than six decades. After numerous well-funded and well-meaning attempts to repeal Glass-Steagall over the last six decades, why was it finally repealed in 1999? Three important 2. First: increasing weight of empirical evidence generated by academics. A number of studies found that the securities activities of commercial banks bore little responsibility for the banking traumas of the Great Depression. For example, Kroszner and Rajan (1997) showed that, partly because commercial banks dealt with older and larger firms, the securities that they underwrote performed better than those underwritten by investment banks. 3. Second: more recent experience. Regulators had allowed U.S. banking companies to undertake limited securities and insurance activities in recent years. By the end of the 1990s, few U.S. banking problems had been attributed to the wider range of permitted activities. Advocates of repealing Glass-Steagall also cited the extensive experience from other developed countries of banking companies that had securities and insurance businesses as providing support for the repeal of Glass-Steagall. 4. Third factor: rapid technological advance that has already markedly reduced the costs of using data from one business to benefit another business, and is expected to reduce such costs further in the future. These cost reductions raised the expected profitability of cross-selling insurance and securities products to both household and business customers. Together, these three factors added powerfully to the case for repealing Glass-Steagall. 5. In many ways, the barriers between banking and other financial industries had been crumbling for some time even before the passage of the GLBA, as a result of regulatory decisions and earlier legislation. As such, GLBA is better seen as ratifying and extending changes that had already been made, rather than as revolutionary. 6. Glass-Steagall barred national banks and state-chartered, Federal Reserve member banks from investing in shares of stocks, limited them to buying and selling securities as agents, and prohibited most from underwriting and dealing in most securities. It also prohibited Federal Reserve member banks from being affiliated with any company that is "engaged principally" in underwriting or dealing in securities. It made it unlawful for securities firms to accept deposits, and prohibited officer, director, or employee interlocks between a Federal Reserve member bank and any company "primarily engaged" in underwriting or dealing in securities. Certain securities were exempt from Glass-Steagall restrictions, including municipal general obligation bonds, U.S. government bonds, private placements of commercial paper, and mortgage-backed securities. These are collectively called "bank-eligible securities." All other securities are deemed "bank-ineligible securities." 7. However, the terms "engaged principally" and "primarily engaged" were not defined in Glass-Steagall. Similarly, a bank holding company or its nonbank subsidiary could engage in nonbanking activities, including securities activities, as long as the Federal Reserve determined that the activities were "closely related to banking." Beginning in 1987, based upon such interpretative freedom, the Federal Reserve allowed bank holding companies to establish securities subsidiaries to engage in limited underwriting and dealing in municipal revenue bonds, mortgage related securities, consumer-receivable related securities, and commercial paper. Since the authorization for dealing with these technically bank-ineligible securities was authorized by the Fed under Section 20 of Glass-Steagall, the securities affiliates are commonly referred to as "Section 20 subsidiaries." At first, the Federal Reserve decided that the revenues from bank-ineligible securities activities could not exceed 5 percent of Section 20 subsidiary's total revenue. Then, in 1989, it raised the limit on revenue from bank-ineligible sources from 5 percent to 10 percent and allowed underwriting and dealing in all debt and equity securities. In 1997, the Fed further raised the limit on revenue from bank-ineligible sources to 25 percent. Because of such revenue limits, only the largest bank holding companies were able to own full-line investment banks. Even so, there are now more than 40 Section 20 subsidiaries. GLBA eliminated these revenue limitations altogether. It further allowed securities underwriting to be done in financial subsidiaries of banks and financial holding company affiliates. Restrictions on securities activity by banks had been further relaxed in recent years by state laws and by a determination by the Federal Deposit Insurance Corporation (FDIC) in 1984 that Glass-Steagall did not apply to affiliates of banks that were not Federal Reserve members. Roughly half of the states have authorized affiliates of such banks to deal in securities beyond the limits established for member banks. Furthermore, U.S. banking companies have long been permitted to engage in securities activities outside the United States through foreign subsidiaries. 8. Banking companies and their customers may benefit from the expanded range of permissible activities under GLBA in several ways. For banks, scope economies are the most likely sources of greater profitability. Certain fixed overhead costs of collecting, processing and assessing information can occur once, and then be used across a range of financial services. Banks can also use existing technology, personnel and delivery channels to distribute securities and insurance services-along with their traditional lending-at relatively low marginal cost. Continuation of the declines in the real costs of data processing and telecommunications arising from technological advance may fuel even greater scope economies in the future. Finally, there may be economies coming from spreading overhead in administration, back office operations, and information technologies over a wider base of financial services. 9. Two main concerns arise when banking, securities and insurance activities are combined within the same banking organization. The wider range of activities might increase the risk of insolvency. However, a wider range of activities can also reduce insolvency risk by increasing diversification. The second concern is whether banks receive a subsidy, based on the way that federal deposit insurance and access to the payment system and the discount window of the Federal Reserve are implemented, that could be extended to cover the broader range of financial activities. If so, holding companies with bank subsidiaries would have an unfair advantage over their nonbank competitors. Even if there were net marginal subsidies from the federal safety net that accrued to banks, adequate safeguards appear to exist to inhibit banks from passing them through to the other, affiliated subsidiaries of their holding companies. 9. It is sometimes alleged that GLBA will accelerate the already rapid pace of mergers of banks and of holding companies. By its nature, GLBA is likely to stimulate primarily mergers that expand banking firms' scope of product and service offerings. GLBA allows banking, finance, and insurance to be undertaken within a single holding company. However, by 1994, the Riegle-Neal Act had effectively ended the remaining barriers to interstate banking and branching within the United States. Combinations with foreign banking companies have generally been permitted as well. Thus, GLBA does not much change the incentives and abilities to merge across state and national boundaries.GLBA will now permit broad banking companies that can engage in banking, securities, and insurance activities. The combined assets of commercial banks, insurance companies, securities firms, and investment companies are almost two thirds of the assets of all financial intermediaries. To the extent that these now largely separate companies combine as permitted by GLBA, broad banking companies will regain some of the market share that they had more than a century ago.

History of Sanctions

1. Governments have always restricted activity with enemies 2. President Wilson advocated sanctions as a substitute for war. They were built into the League of Nations framework but little used 3. US and US led sanctions involving finance as a peacetime policy have proliferated for a number of objectives: A) Cold war residuals (Cuba and North Korea), B) Curb bad behavior: South Africa (1986), Syria (1986), Iraq (1990) , Burma (1997), Sudan (1997) Russia (2014), C) Respond to provocation : Iran (1979), Libya (1988), D) Other objectives: 1) non proliferation (multiple legislative authority, some with little discretions), 2) Specific US concerns (1974 Jackson-Vanik amendment targeted Soviet barriers to Jewish emigration) 4. UN sanctions have become much more frequent since the end of the cold war: Serbia, Iraq, Iran, North Korea, Congo, Cote d'Ivoire, Liberia, Sudan... 5. Emergence of threats from non state actors have led to sanctions against individuals and organizations: A) Patriot Act established sanctions against Specially Designated Nationals linked to terrorism, B) UN sanctions have been put on a non-state actor--Al Qaida

History of junk bonds

1. Had been junk bonds from time to time in the past—Alexander Hamilton's refinancing of Revolutionary War debt were a precursor 2. In late 1976 Lehman Brothers underwrote a non-investment grade issue 3. Michael Milken, who ran a fallen angel trading group at Drexel Burnham Lambert, saw the opportunity, knew the investor base and quickly built up a new issuance business 4. Junk bond financing of hostile leveraged buyouts made them controversial in the mid 1980s 5. Junk bonds also financed companies in new or changing industries—cable TV, telecoms, airlines 6. Milken charged with insider trading in 1986; he and 7. Drexel pled guilty in 1989 8. Drexel filed for bankruptcy in 1990 when it could not sell off its junk bond portfolio since it so dominated the market 9. Market has continued trend growth with cyclical ups and downs

Management's Interests and Shareholders' Interests (Cheng, Hong, Schenkman)

1. Higher pay adjusted for firm size is associated with more risk taking 2. Risk is in line with what shareholders want 3. Shareholders sort themselves with short-term risk seekers going to firms that take more risk 4. Volatility is most valued by institutional investors

Glass-Steagall Act

1. Historically, the U.S. financial system has undergone increasing levels of regulation over time. 2. The National Bank Act of 1863 generally limited the types of activities that could be conducted by national banks to those that are part of, or incidental to, the business of banking. 3. The McFadden Act (1927) limited interstate branch banking, implicitly limiting bank size and geographic diversification. 4. The Banking Act of 1933 (known as Glass-Steagall) separated commercial banks from investment banks. Commercial banks could not underwrite securities,while securities firms could not engage in commercial banking. 5. The Bank Holding Company Act of 1956 prohibited banks from affiliating with companies engaged in commercial activities. 6. However, beginning in the late 1960s, innovation and deregulation gradually eroded these restrictions. Commercial banks lost market share to new financial instruments and institutions such as commercial paper and money market mutual funds. In response, banks were allowed to expand and diversify their activities. 7. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 significantly eased interstate banking restrictions. 8. The Gramm-Leach-Bliley Act of 1999 expanded the range of financial activities that may be conducted by qualifying banking organizations. 9. The early 2000s saw the rise of large, complex FIs engaged in a broad spectrum of financial activities, as well as the rise of a new model of financial intermediation, referred to as shadow banking, in which maturity transformation increasingly took place outside the formal banking sector. In this new model, illiquid and (sometimes) risky assets were funded by asset-backed commercial paper or loans financed by repurchase agreements (repo loans) collateralized with asset backed securities; credit and liquidity backstops of liabilities were implicit rather than explicit; and capital requirements and other restrictions were less stringent for shadow banks than for traditional banks.

"Innovating Our Way to Financial Crisis" by Paul Krugman

1. How did things get so opaque? The answer is "financial innovation" — two words that should, from now on, strike fear into investors' hearts. 2. O.K., to be fair, some kinds of financial innovation are good. I don't want to go back to the days when checking accounts didn't pay interest and you couldn't withdraw cash on weekends. 3. But the innovations of recent years — the alphabet soup of C.D.O.'s and S.I.V.'s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn't have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized. 4. The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.

Consumer protection in the absence of insurance?

1. How much should one be concerned that supervision leads to loss of market discipline? 2. Suggests it should not be done if it can't be done well (enforcement of segregation in MF Global)

Functional efficiency

1. How well markets are performing their function as the nervous system of the economy 2. This needs to be in focus in consideration of any policy 3. CAPM and information-arbitrage efficiency would produce this

Have covered a lot of ground (1)

1. Idealized markets 2. Market imperfections: A) Herd behavior, B) Bubbles, C) Unstable liquidity, D) Principle agent problems, E) Asymmetrical information, F) Market power asymmetry, G) Cognitive biases

Overview of Sanctions

1. Imposition of economic and financial sanctions has become a regular tool of US foreign policy 2. An intrinsically international policy 3. The US has imposed sanctions on: A) narrow activities (often finance), B) Most or all dealings with the country 5. Usually an effort to obtain multilateral support, but in a number of cases sanctions have been unilateral

"Inside Debt, Bank Default Risk, and Performance during the Crisis" by Rosalind Bennett, Levent Guntay and Haluk Unal

1. In 2006 higher holdings of inside debt relative to equity by a CEO after controlling for firm leverage is associated with lower default risk and better performance during the crisis period 2. Evidence that before the crisis banks with higher inside debt ratios also have supervisory ratings that indicate stronger capital positions, better management, stronger earnings, and being in a better position to withstand market shocks in the future 3. These findings imply that there is an important role for the inside debt ratio as a signal of the risk-taking incentives of the banks' executives

"Community Financial Access Pilot Report" by US Treasury

1. In many communities, especially those that have faced years if not decades of financial decline, challenges and needs are great and providing access to financial education and financial services may be seen as a "drop in the bucket," and therefore it may be difficult to garner community interest and support in what is seen as yet another new program which in untested in bringing about significant community improvement. 2. For individuals with long histories of a lack of education (not just financial education), and a lack of trust in mainstream economy, education and gaining trust is a long term process and will not be turned around quickly. Additionally, many LMI individuals and families face a number of challenges, so that it beginning to address them faces a range of difficulties. For example, even if someone wants to open a bank account, he or she may not work for an employer who offers direct deposit, or he or she may have outstanding debts to pay off prior to building savings. Many individuals have poor credit histories and/or ChexSystems records that may serve as barriers to opening accounts. 3. The changing financial and regulatory environment may also affect not just products and services offered by financial institutions, but also their ability to engage in community activities and support non-profit organizations. Similarly, decreased availability of state and local government funding and other support for non-profit organizations may make it more challenging for such entities to assist in these efforts, even as the need is as great or greater than ever. 4. Recognizing the value of people is above all one of the most crucial elements to a successful initiative. In every community, as well as communities around the country, we have seen that what makes these programs successful is the commitment and effort of dedicated, passionate individuals who want to make the project work. With such commitment, obstacles can be overcome, creative solutions found, and most importantly, minds changed.

Moral hazard in finance

1. Institutions covered by deposit insurance enjoy a lower cost of funds because depositors or buyers of their debt have no risk of loss 2. When a bank's net worth is gone, management has an incentive to increase risk taking 3. Many worry that lender of last resort activities and other government interventions in a crisis create moral hazard

Insurance and Moral Hazard at Citicorp

1. Insurance can create the illusion that banks don't need capital, a view taken by Walter Wriston, CEO of Citicorp in the 1970s 2. Citicorp/bank/group has had three near death experiences since and would have succumbed each time without government support 4. But there has been no cost to insurance funds and in the last episode a profit to taxpayers

"For Better or For Worse: Default Effects and 401(K) Savings Behavior" by James Choi, David Laibson, Brigitte Madrian and Andrew Metrick

1. In the last several years, many employers have decided to automatically enroll their new employees in the company 401(k) plan. Using several years of administrative data from three large firms, we analyze the impact of automatic enrollment on 401(k) participation rates, savings behavior, and asset accumulation. 2. We find that although employees can opt out of the 401(k) plan, few choose to do so. As a result, automatic enrollment has a dramatic impact on retirement savings behavior: 401(k) participation rates at all three firms exceed 85%, but participants tend to anchor at a low default savings rate and in a conservative default investment vehicle. 3. We find that initially, about 80% of participants accept both the default savings rate (2% or 3% for our three companies) and the default investment fund (a stable value or money market fund). Even after three years, half of the plan participants subject to automatic enrollment continue to contribute at the default rate and invest their contributions exclusively in the default fund. 4. The effects of automatic enrollment on asset accumulation are not straightforward. While higher participation rates promote wealth accumulation, the low default savings rate and the conservative default investment fund undercut accumulation. In our sample, these two effects are roughly offsetting on average. However, automatic enrollment does increase saving in the lower tail of the savings distribution by dramatically reducing the fraction of employees who do not participate in the 401(k) plan.

Money Market Mutual Funds: What happened?

1. In the midst of the post-Lehman crisis in September 2008, The Reserve Primary Fund, which held Lehman paper, "broke the buck"—it reported a net asset value of less that $1 2. Investors began to pull money out of MMMFs and a massive run threatened 3. The Treasury used the Exchange Stabilization Fund to guarantee MMMF accounts temporarily 4. Very low interest rates have perpetuated the risk of an MMMF again breaking the buck even with a lesser shock than Lehman 5. Risk of a repeat was a widespread concern, especially in an environment of ultra low interest rates 6. The SEC failed to approve reforms in August 2012 7. The FSOC has approved reform proposals but will still need SEC approval and implementation 8. Final outcome is uncertain

Modigliani-Miller

1. In theory, the cost of lending should be insensitive to equity requirements 2. Modigliani and Miller showed that under some basic assumptions, the sum of the total value of a corporation's equity to its owners plus the total value of its debt to its creditors should be equal to the total value of its income-earning assets 3. In other words, the relative portions of debt and equities in a portfolio should not affect how much it costs to issue equities or debt to finance that portfolio 4. Thus if a bank suddenly decides that equities represent the most sensible financing option, the cost of lending should not rise 4. Similarly, if a government decides that equities represent the most sensible financing option for banks, the cost of lending also should not rise

Sales forces

1. In virtually every industry the sales force is intensively incentivized by commissions 2. Output is measurable 3. This approach fails to incorporate other objectives: A) Sales with long-term costs from lost reputation or litigation B) Sales people responsible for alternative products compete within the firm—internal conflicts are rife 4. The problem of commission driven sales forces is evident in the mortgage brokerage business before the crisis and in the marketing of proprietary products by retail brokers. It is an internal problem in origination not necessarily related to risk in investment and commercial banking. Except that due diligence was lax in mortgage securitization (By underwriters, by credit rating agencies and by buyers).

The weak link of corporate governance across sectors—the Board

1. Incentives are weak 2. Cronyism is rampant 3. Either insiders with potential conflicts or outsiders with thin expertise 4. Accountability to shareholder mechanisms are weak

Unintended consequences of market and regulatory innovation with regard to systemic risk

1. Incentives for regulatory gaming 2. What will the new shadow banks be?

Do shareholders and the public have different interests when it comes to compensation incentives for risk taking?

1. Incentives for risk taking may be higher than optimal for shareholders: A) Moral hazard owing to government support, B) Externality of creating a risky environment, C) Selection of risk lovers among shareholders 2. But shareholders and regulators have a common interest in reducing the value of the put embedded in employee compensation

The interaction of innovation and policy

1. Innovation may be a response to a regulatory distortion 2. Innovation may require policy support to create needed infrastructure 3. Innovation frequently leads to new risks or potential for abusive practice 4. Innovation mobilizes incumbents in the industry who are not well placed to adopt an innovation to seek protection from policymakers (especially if they are foreign)

"Insider Trading: A Review of Theory and Empirical Work" by Ako Duffou

1. Insider trading theories stress the important role that information plays in the capital markets. Excess returns generally accrue to those with the most complete information sets. This is why managerial motivations were discernible from their transactions in their own firms' shares. 2. Most research has employed the record of insiders' transactions as supplied by the insiders themselves to the regulatory authorities. While this approach may have been appropriate in a time when the likelihood of prosecution was minimal, the advent of increasingly severe penalties calls into question the accuracy of this database for many of the empirical questions to be answered. In the face of severe penalties, rational insiders will either not trade or will attempt to disguise their actions. 3. Because of the increasingly severe penalties, sophisticated investors attempt to use alternative financial instruments (e.g. junk bonds) and strategies to profit from nonpublic information. Currently, regulators make the false assumption that insiders strictly limit their transactions to common stocks. 4. Future research should also attempt to identify the identities of outside-insiders, the nature of their transactions, and most importantly, how widespread outside-insider trading is. As of today, the volume of aggregate insider trading has not been significantly reduced. This leads us to question the effectiveness of insider trading regulation. Should regulation be redesigned or should taxpayers and investors stop putting their money in a heavy administrative system that has so far provided a questionable return?

Ways to think about and organize financial supervision and regulation

1. Institutional (banks, broker-dealers, insurance...) 2. Functional (Securities, bank deposits, payments..) 3. Objectives (systemic stability, investor protection, taxpayer protection) 4. Unitary (for organizing, not for thinking)

Some activities have been found to have little synergy

1. Insurance manufacturing/ asset management 2. Mass market retail brokerage 3. Securities origination: A) Citi and BofA/ Merrill Lynch sold asset management businesses, B) Citi sold its Travelers Insurance business 4. Securities sales and trading: A) Goldman has never had a mass market brokerage, B) Citi sold Smith Barney Market pressure can force correction of combinations that don't work without regulatory action

Money Market Mutual Funds: Why was there failure

1. Intense industry lobbying outweighed the nearly universal view of those knowledgeable about the issue who did not have a personal interest: Concentrated benefits and dispersed benefits (saving taxpayers from risk) led to a revolving door 2. These led to regulatory capture

"Money Laundering and Terrorism Financing: An Overview" by Jean-Francois Thony

1. International strategies and standards for combating money-laundering have been in development for a period of less than fifteen years, which in terms of law-making, would still be considered to be in its early stages. Yet, the environment in which organized crime develops is constantly evolving. New threats, particularly that of terrorism and its financing, require ongoing review of the validity of the strategies put into place. Moreover, the balance sheet in the fight against money-laundering is very mixed. Many financial markets, and particularly tax havens, offer too many shelters for drug traffickers and money-launderers. The transparency that has been introduced into financial transactions has not been reproduced at the level of corporate law. International judicial cooperation is in its infancy and does not provide the ability to respond quickly enough in view of the nearly instantaneous speed of electronic funds transfers. 2. Should we, therefore, question the effectiveness of the current strategy? In fact, the strategies are sound, however, it must be noted that the objectives the international community set for itself in combating money laundering and terrorism financing are far from being attained, given the lack of universal implementation of the established standards. It is on this point that all efforts must henceforth be brought to bear, in order to ensure sufficient financial transparency for tracking the movements of funds of criminal origin. The mobilization of governments must be incessantly pursued, and the collaboration of both the financial sector and more generally the private sector must also be thorough.

History of CDS

1. Invention attributed to Blythe Masters at JP Morgan in 1994 (Masters was 25 then; was until recently Head of Global Commodities at JP Morgan, which was sold; she resigned and is under investigation for JPM activities in electricity markets.) 2. Was initially a tool for banks to distribute risk in their loan portfolios 3. Hedge funds and other trading portfolios actively arbitraged CDSs and the credits associated with them 4. They also became a vehicle for speculation 5. Synthetic CDOs were made from CDSs and large exposures created stress in the recent crisis (AIG) 6. The notional value of CDSs outstanding reached $46 trillion in mid 2007, then fell by more than half and was $22 trillion in mid 2012. It has dropped further to $10.7 Trillion in the first week of March 2014

Implicit and Explicit Extension of Deposit Insurance

1. Investors have been made whole on uninsured as well as insured deposits and other bank liabilities in failures 2. After the Lehman collapse, The US government guaranteed holdings in money market mutual funds to stop a run 3. Fannie Mae and Freddie Mac were backed by the government despite years of statements that they were not insured beyond a small amount. 4. Lehman bothers was not a bank, but it was a shock to the market that it did not enjoy de facto insurance 5. Goldman Sachs and Morgan Stanley quickly became bank holding companies to have access to government support

The innovation of junk or high-yield bonds

1. Issuance of corporate bonds with significant credit risk attached to them and a correspondingly higher interest rate 2. Before the emergence of junk bonds, non investment grade securities were "fallen angels"--bonds issued with an investment grade rating whose issuer had deteriorating credit

Problems Created by Eurodollars

1. Issues of separation or integration of Eurodollar market and US domestic market: A) Monetary policy, B) Exchange rate policy 2. Clearing and settlement infrastructure (Herstatt Bank failure, 1974) 3. Undermined competitiveness of the US (New York) as an international financial center 4. How to supervise banks in this business? 5. Facilitated systemic imbalances—recycled petrodollars led to Latin American Debt crisis of 1982

"JP Morgan fined £570m over 'London Whale' trading losses" by Joseph Charlton

1. JPM agreed to pay $920m to four separate regulators in compensation for the $6.2bn trading losses it accumulated during the 'LondonWhale' debacle in 2012 2. A little less than a quarter of that sum ($220m) will be paid to the UK's Financial Conduct Authority (FCA) while the rest of the balance will go to the US OCC, the FRB and the SEC

Dealers in Mortgage Markets

1. Just as in other bond markets, dealers play an important role once an issue is initially distributed. For most bond investors, liquidity—the ability to easily buy or sell a security—is an important characteristic. 2. By offering prices at which they will buy or sell bonds to the investment community, dealers provide this service. 3. Bonds typically trade more actively closer to their date of issue. 4. Because bond investors—usually institutional investors such as pension funds and insurance companies—hold most bonds to maturity, trading in bonds declines as they draw nearer to their stated maturity date. 5. The issuance volume of a certain bond, a bond's credit rating and whether it was issued publicly or privately can also affect liquidity. 6. All ABS and MBS are traded on the dealer-based, over-the-counter markets so liquidity depends in part on the ability and willingness of dealers to maintain an inventory, or make a market, in a certain bond.

Size and scope issues are not dealt with in a coherent way in the US

1. Justice Department responsibility for antitrust 2. Some market structure regulatory issues in the hands of the Federal Reserve: Merger approval 3. Congress has been active in responding to strong voices: A) Graham Leach Bliley, B) Dodd Frank

Problems created by CDS

1. Lack of transparency in markets 2. High level of risk taking relative to hedging and arbitrage 3. Hidden counterparty risks 4. Liquidity risks from collateral calls 5. Uncertainty about what would constitute a credit event (Greece)

Size of financial institutions

1. Largest banks in the US are small relative to the economy 2. US banks are also not absolutely much larger than others

"On the Efficiency of the Financial System" by James Tobin

1. Late career reflections on systemic efficiency by a pioneer of modern financial economics written almost 30 years ago 2. Evaluates financial system on the basis of four criteria for efficiency 3. Concludes that in many respects financial system serves us as individuals and as a society very well indeed 4. However, it does not merit complacency and self-congratulation either in the industry itself or in the academic professions of economics and finance 5. Its shortcomings not entirely attributable to government regulations and not likely to disappear with deregulation

Shafer's Approach to Compensation Policy

1. Legislation should empower supervisors to impose conditions on compensation structures in financial institutions. 2. Supervisors should focus on the structure of compensation rather than the level: A) Ties of executive comp to debt look interesting but not overwhelmingly proven so one would not want to lock in this approach, B) Return incentives to traders should be moderated to reflect capital usage and allow for clawback 3. Legislation should empower regulatory approach as a fallback to softer supervision 4. Avoid setting ceilings on compensation in one sector: Issue is distributional and if one were to scale back large compensation it should not be limited to one sector or part of one sector

"September 2008: The Bankruptcy of Lehman, Chapter 18" by FCIC

1. Lehman's collapse demonstrated weaknesses that also contributed to the failures or near failures of the other four large investment banks: inadequate regulatory oversight, risky trading activities (including securitization and over-the-counter (OTC) derivatives dealing), enormous leverage, and reliance on short-term funding 2. Lehman, like other large OTC derivatives dealers, experienced runs on its derivatives operations that played a role in its failure 3. Lehman's failure resulted in part from significant problems in its corporate governance, including risk management, exacerbated by compensation to its executives and traders that was based predominantly on short-term profits 4. Federal government officials decided not to rescue Lehman for a variety of reasons, including the lack of a private firm willing and able to acquire it, uncertainty about Lehman's potential losses, concerns about moral hazard and political reaction, and erroneous assumptions that Lehman's failure would have a manageable impact on the financial system because market participants had anticipated it 4. The inconsistency of federal government decisions in not rescuing Lehman after having rescued Bear Stearns and the GSEs, and immediately before rescuing AIG, added to uncertainty and panic in the financial markets

The Classical LoLR

1. Lends only on good collateral to solvent institutions 2. Lends at a penalty rate 3. Lends in unlimited large amounts (Walter Bagehot. Lombard Street, 1873)

Is finance different from other businesses? (General Compensation Issues)

1. Leverage 2. Externalities of risk 3. Complexity and lack of transparency 4. Can the large corporate model work in finance?

The innovation of Collaterized Debt Obligations (CDOs)

1. Loan or bond debt sold to a special purpose vehicle (SPV) 2. SPV financed by securities giving a claim to a share of the cash flow from the debt obligations 3. Securities structured in tranches (French for slices) ranging from first claim (super senior) through middle claims (mezzanine) to the residual claim (equity) 4. Got debt off the balance sheets of banks, allowing more growth of credit and reducing the capital tied up 5. Distributed the risk of the portfolio and provided a range of risk to investors with differing appetites

JP Morgan's Whale

1. London Whale lost more than $6.2 billion for JPMorgan: the bank still earned record profit of $21.3 billion. 2. Two former traders face criminal charges, the bank admitted violating securities laws and agreed to pay fines of more than $1 billion, a U.S. Senate subcommittee wrote a scathing report and the bank's chief executive, Jamie Dimon, took a pay cut. it raised a worrisome question: What if the banks are still addicted to risk? 2, Neither the Whale himself, Bruno Iksil, nor any senior managers were charged. The August indictments were against Iksil's former boss and a junior trader, and the charges weren't about the trades themselves — U.S. prosecutors say the pair committed securities fraud by hiding the true extent of losses from bank management. Senate report said the bank misled investors and dodged regulators as losses mounted. In October 2013, however, the bank reported the first quarterly loss of his tenure, with results weighed down by $7.2 billion in legal costs. The bank agreed to a $100 million settlement with the Commodity Futures Trading Commission, which found that it had deployed a reckless trading strategy. 3. In a sense, what Iksil and his colleagues did was the same old story — doubling down after a loss with bigger and bigger bets. But plenty more was wrong. They worked in a part of the bank, the Chief Investment Office, whose job was to hold down the bank's risk level. Instead, the CIO used the $350 billion it had to invest (much of it from federally insured deposits) to become a moneymaker, with its London office focused on complex derivative trades that had less and less to do with hedging. In 2011, for example, one trade by Iskil brought in $400 million. The trouble came in early 2012, when the bank decided to reduce the risk in the London swaps portfolio by making more offsetting bets. As the strategy unraveled, Iksil's positions grew so big that they disrupted the thinly traded markets he worked in — earning him nicknames of Whale and Voldemort, and making his group's hard-to-unwind trades a target for hedge funds. After the trades collapsed, regulators found that Iksil's colleagues had been keeping two sets of books to minimize the projected size of the losses — a discovery that triggered investigations in the U.S. and U.K. 4. Dimon called the trades "flawed, complex, poorly reviewed, poorly executed and poorly monitored." The Senate report had showed systemic failures: Risk limits, for instance, were breached more than 300 times before the bank switched to a more lenient risk-evaluation formula — one that proved to underestimate risk by half because of a spreadsheet error. To critics of Wall Street, the real lesson of the London Whale is that megabanks such as JPMorgan are not only too big to fail — they're too big to manage.

The two liquidity spirals

1. Loss spiral 2. Margin spiral

Problems created by S&Ls

1. Losses to taxpayers 2. A broken housing finance system that was fixed by the creation of industrial originators and securitization of mortgages—roots of the next crisis

Criteria for Judging LOLR Operations

1. Made or lost money 2. Path of output and prices (always room for counterfactual debate)

Bernie Madoff's Ponzi Scheme: What happened?

1. Madoff ran an investment fund alongside a brokerage that focused on unlisted (NASDAQ) securities 2. At some point (Madoff says in the 1990s) he began claiming returns higher than actual returns and paying investors out of new funds raised—a classic Ponzi scheme 3. Madoff had been Chairman of NASDAQ and a board member of the Securities Industry Association 4. Strong and stable reported returns and effective personal marketing brought in funds from prominent institutions and investors: A) Stephen Spielberg, Kevin Bacon, Larry King, B) The Wilpon family (owners of the Mets), C) HSBC, Banco Santander and their clients 4. Exposed in 2008 when financial crisis led to large withdrawals 5. Size of scheme put at $64.5 billion—largest in history

Enforcement of sanctions

1. Many laws and international agreements with different scope 2. US administration of financial sanctions falls under the Office of Foreign Assets Control (OFAC ) within the Treasury Department: A) Historically independent within Treasury and insulated from industry capture, B) Requirements complex but relatively transparent (one can always call OFAC and ask), C) Compliance can nevertheless be onerous 3. Global coordination: A) UN Security Council establishes committees for each set of UN sanctions, B) "Coalition of the willing" sanctions coordination is ad hoc

Forms of Control of Economic Activity

1. Market (laissez faire) 2. Litigation (enforcement of contracts) 3. Shape the market environment: A) Legislation (establish rules), B) Regulation (elaborate and enforce the rules), C) Law enforcement (sanction violations of law and regulation) 4. Ownership (provide services directly) History shows that governments are much more effective as rule makers and referees than as players in the economy. Government ownership tends to become effectively manager or worker ownership. Oversight is weak (pollution control in the Soviet Union)

Drivers of CDS innovation

1. Market conditions: A) Growing investment community with an appetite for risk, B) Demand for single risks (credit without interest rate) 2. Regulatory conditions: Basel Capital Standards created an incentive for banks to distribute risk in their portfolios 3. Technology: Quantitative techniques created a capacity to analyze quickly arbitrage relationships

Drivers of CDO Innovation

1. Market conditions: A) Strong market for highly rated assets, B) Upward spiral of booming housing market and strong performance of mortgage backed securities 2. Regulatory conditions: A) Basel capital standards incentivized banks to distribute their loan portfolios, B) Basel Capital standards also favored securitized debt over loans on bank balance sheets

Legacy of Junk Bonds

1. Market has survived 3 downturns 2. Record US issuance in 2012--$346 billion (2013 was off a bit) 3. Has played an important role in change and growth in the US economy for 3 decades 4. Has spread to markets in Europe and Asia 5. Paved the way for the development of a sovereign bond market for emerging markets

Curbing size to curb power

1. Market power is a potential real concern: A) Has been more evident in local markets than nationally in the US, given historically fragmented structure, B) Globally, capital markets underwriting has become concentrated: the top 5 firms underwrite 33 % of debt and 41 % of equity 2. There may be a tradeoff between allowing large institutions nationally and maintaining competition locally, especially in smaller markets: A) But this depends on the product: consumer deposits are a local market, credit cards are marketed nationally, B) Regulators look at local markets when mergers are considered

7 thoughts to take away

1. Markets and governments are imperfect institutions but they have enabled tremendous economic benefits to be created and distributed among people in a large part of the world 2. They are not substitutes but complementary institutions 3. Incentives in markets and politics explain a lot, but not everything 4. Few policy issues are as obvious as they are often presented 5. There is a payoff to analysis in finding best policy tradeoff: A) Theories provide a framework, B) Data provide answers when used carefully 6. Whether making policy or working in the markets, one often can't wait for all the information and all the analysis to make a decision 7. This means be prepared to adjust course when more information arrives

Why might markets be informationally inefficient

1. Markets just look that way when one ignores the risks—one can go broke holding a short position waiting for the market to come to its senses 2. Regulatory constrains make full arbitrage impossible or costly e.g. restrictions on short-selling, capital controls 3. Smart money rides along with or is overwhelmed by the "dumb" money (not only lack of information but also behavioral finance)

Elements of Insider Trading

1. Material: Information is material if there is a substantial likelihood that: A reasonable shareholder would consider the fact important in deciding how to trade and disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available 2. Non-public: Non-public information is information that has not been disseminated in a manner making it generally available to investors. Information is public when it is widely available in the public domain, such as in press releases, media articles, and SEC filings. After material information is disclosed into the public domain, you need to wait until public investors have had time to react to the information if you previously possessed inside information. 3. Duty 4. Trading in connection with 5. Scienter: Latin for "having knowledge." In criminal law, it refers to knowledge by a defendant that his/her acts were illegal or his/her statements were lies and thus fraudulent

Innovation may be a response to a regulatory distortion

1. May reflect unplanned consequences of policy in a changed environment (money market mutual funds in the early 1970s when the level of market interest rates rose above rate ceilings for bank deposits (Regulation Q)) 2. May be straight forward evasion of intent of the regulation (SIVs)

How governments intervene is complex

1. Models of government 2. Objectives 3. Powers of the state 4. Forms of control 5. Complex interactions 6. Behavioral government/wrong incentives 7. Capacity and culture

Systemic liquidity in normal times

1. Monetary policy shapes the availability of liquidity to those in the market by changing the supply of the most liquid assets—transferable Federal Funds balances and currency 2. Most liquidity is provided by financial institutions; how they do this normally changes only slowly though innovation e.g. invention of the credit card, HELOC, MMMF 3. Hence what the Fed supplies shapes liquidity conditions (interest rates) in the short run but it must adjust to how markets are changing over time

"Ex SAC Trader Found Guilty" by Christopher Matthews and John Carreyou

1. Mr. Martoma, who worked at SAC for four years but was fired in 2010, was accused of trading using inside information provided by two doctors, Sidney Gilman and Joel Ross, about the trial of an Alzheimer's drug being developed by Elan Corp. and Wyeth Pharmaceuticals. Elan is now part of Perrigo Co., and Wyeth is part of Pfizer Inc. Both doctors testified that they passed inside tips on drug tests to Mr. Martoma. 2. Prosecutors have long pursued Mr. Cohen, who built one of the country's most successful hedge funds over the past two decades and managed more than $15 billion at the firm's peak. He has denied involvement in any wrongdoing and hasn't been charged criminally, but he faces a civil allegation by the Securities and Exchange Commission that he failed to adequately supervise two senior employees at his firm.

Money Market Mutual Funds: Lessons learned

1. Multiple avenues for action may help: A) FSOC engagement is giving reforms a second chance, B) Industry influence on Aguilar may have been overcome—he has signaled a willingness to reconsider 2. Breaking down agency silos may help to reduce the weight of narrow interests: FSOC members represent a broader set of interests and are less captured as a group by a narrow industry position (but they are all close to the broad financial industry)

A "Belt and Braces" philosophy of regulation

1. Multiple overlapping regulatory requirements may reduce opportunities for gaming and regulatory arbitrage e.g. capital requirements and leverage ratio 2. This sets a limit on pushing funds into low weighted assets to boost leverage and on taking on only high risk assets within a leverage ratio 3. Redundancy is not always bad

Market Power in the US

1. Nationally, in the US, market power of leader varies by product 2. Credit cards and syndicated loans are national markets. Does Amex have market power? 3. Wells Fargo mortgage market share of 23.5% must mean much higher share in many markets

"Financial Innovation and the Management and Regulation of Financial Institutions" by Robert Merton

1. New security designs, improvements in computer and telecommunications technology and advances in the theory of finance have led to revolutionary changes in the structure of financial markets and institutions. 2. Merton's conjecture as to why there is this anxiety or strong focus on the risks of the new activities is that their implementation has required major changes in the basic institutional hierarchy and in the infrastructure to support it and that the knowledge base required to manage this part of the system is significantly different from the traditional training and experience of many private-sector financial managers as well as regulators. 3. Changes of this sort are threatening. It is difficult to deal with change that is exogenous with respect to our traditional knowledge base and framework and therefore seems outside of our control. Less apparent understanding of the new environment can create a sense of greater risk even if the objective level of risk in the system is unchanged or reduced.

"Bank CEO Incentives and the Credit Crisis" by Rudiger Fahlenbrach, and René Stulz

1. No evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse both in terms of stock returns and in terms of accounting return on equity 2. Further, option compensation did not have an adverse impact on bank performance during the crisis 3. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis; further, there is no evidence that they hedged their equity exposure 4. Consequently,they suffered extremely large wealth losses as a result of the crisis

Impact on Finance of the Foreign Corrupt Practices Act

1. Not a high profile sector for cases in the past (Infrastructure and aerospace were the leaders although current cases involve establishment rights for retail and gaming) 2. JP Morgan's hiring of children and others connected with Chinese government and SOE leadership is a current high profile case 3. UBS is also under investigation for hiring children of Chinese executives of non-state owned companies (doesn't sound like FCPA) 4. Risk exposure for financial institutions in sovereign bond underwriting and privatization as well as local operations 5. Compliance not too burdensome: A) Rules are simply not to do bad things, B) Internal compliance procedures becoming heavier over time, but not unreasonable 6. US firms still took compliance more seriously than Europeans a few years ago (but Siemens may have changed that)

Did JP Morgan cross a line in FCPA Case?

1. Not per se illegal to hire well connected young people (it would be discriminatory if it were): A) It was standard practice with private sector US clients at Citigroup, B) Avoidance of a quid pro quo appearance was an understood line that should not be crossed in hiring children of foreign governments or state owned enterprises 2. The "sons and daughter" program was very close to, if not over, the line; Dimon's dealing with the approach to him seems on the permitted side How to deal with hiring and job request for hiring of children of government officials will become one more compliance headache for international bankers

Current Liquidity Ratios

1. Objective is to ensure high quality assets to cover 30 days of stress runoff 2. A stronger criterion would be to have assets maturing faster than liabilities 3. Also look at "net stable funding" ratio—reduce reliance on short-term market funding

"JP Morgan's Loss: Bigger than "Risk Management" by Robert Kaplan and Annette Mikes

1. One academic view of the stakes 2. They argue that that risk management (with all its risks) is a viable, valuable, and learnable practice for organizations — but it works only if it is tailored to the context in which it is deployed and is not taken for granted 3. Furthermore, they point out that a large loss in itself is not evidence of a risk management failure, because a large loss can happen even if risk management is flawless

Markets in Face of Informational Efficiency

1. One implication is that prices of securities normally follow a random walk (adjusted for a risk premium in the return which would introduce drift) 2. New information is reflected in the price immediately "Orderly markets are not necessarily efficient and efficient markets are not necessarily orderly" 3. Efficiency does not exclude frequent small changes in one direction with infrequent large changes in the other

Deviations, Inefficiency and Public Policy

1. One policy problem is that it is almost impossible to spot a deviation when market participants can't 2. Another is that it is hard to know how to correct a problem that could be caused by one of several different forces (Korea crisis of 1998) 3. Inefficiency is zero sum within the market but can have large economic costs through misallocation of investment

Implications of CAPM

1. One takes on risk in proportion to the risk premium and in inverse proportion to risk aversion. 2. The market rewards taking a share of the economy-wide risk in the security (βiRm). 3. The market does not reward taking on security-specific (idiosyncratic) risk (σϵ) and hence diversification of idiosyncratic risk pays. 4. All investors hold a mixture of two portfolios, one riskless (if there is a riskless asset), and the market portfolio. 5. The market takes away positive alpha if it is efficient.

Innovation mobilizes incumbents in the industry who are not well placed to adopt an innovation to seek protection from policymakers (especially if they are foreign)

1. One time Japanese regulation of operating times for ATMs 2. One time Singapore rule that an ATM was a branch and required a branch license, which could be withheld

Servicing

1. Originators often retain a connection to their assets following a securitization by acting as a servicer—the agent collecting regular loan or lease payments and forwarding them to the SPV. 2. Servicers are paid a fee for their work. Some originators contract with other organizations to perform the servicing function, or sell the servicing rights 3. In the vast majority of securitizations, it is critical that the transfer of assets from the originator to the SPV is legally viewed as a sale, or "true sale." 4. The proceeds of the securities are remitted to the originator as the purchase price for the assets. If the asset transfer is not a "true sale," investors are vulnerable to claims against the originator of the assets. 5. The cash flows backing the securities or the assets themselves could be ruled a part of the originator's estate and used to satisfy creditors' claims if a true sale did not occur. Legally separating the assets also protects the originator. 6. Investors can turn only to the SPV for payments due on the ABS and MBS, not to the general revenues of the originator.

"The Obscure Insider Trading Case That Started It All" by Michael Bobelin

1. Over the summer, Rajat Gupta was found guilty of leaking confidential information about Goldman Sachs, where Gupta served as a director, to Rajaratnam. As the former head of McKinsey & Company and a stint on Procter & Gamble's board, Gupta represented the highest-profile executive ensnared by the government. 2. The trades SAC Capital made through Matthew Martoma's alleged insider tips in two pharmaceutical companies, Elan and Wyeth (now owned by Pfizer), earned the fund $276 million through a combination of profits and the avoidance of losses. 3. William Cary ,(SEC Commissioner in 1961),'s administrative opinion, In The Matter of Cady, Roberts & Co., involved a run-of-the-mill example of insider trading. When Curtiss-Wright, one of the pioneers of aviation, decided to reduce the company's dividend, one of its board members, J. Cheever Cowdin, immediately relayed this information to Robert Gintel, Cowdin's associate at the brokerage firm of Cady, Roberts & Company. With this information in hand, Gintel sold thousands of shares held in Curtiss-Wright before the information became public, thereby avoiding losses when the company's stock price dropped as news of its dividend reduction reached the market.

"Neglected Risks, Financial Innovation, and Financial Fragility" by Schleifer, Gennaioli, and Vishny

1. Paper presents a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. 2. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. 3. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. 4. Because the risks are neglected, security issuance is excessive. 5. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.

What happens in financial markets

1. Participants 1) make or receive payments on one date in return for payments received or made on a future date(either fixed or not) or 2) they agree to make an exchange at some date or when a condition is fulfilled in the future 2. Because the future cannot be known, financial transactions are inherently uncertain

Job security and status incentives

1. Penalizes breaking with the pack: contrarianism about big infrequent events can be hard to maintain 2. "As long as the music is playing, you've got to get up and dance. We're still dancing."—Charles Prince CEO of Citigroup, July 9, 2007 3. Was Jamie Dimon of JP Morgan at risk for underperforming peers when he was conservative before the crisis?

Rent seeking

1. People are said to seek rents when they try to obtain benefits for themselves through the political arena. They typically do so by getting a subsidy for a good they produce or for being in a particular class of people, by getting a tariff on a good they produce, or by getting a special regulation that hampers their competitors. Elderly people, for example, often seek higher Social Security payments; steel producers often seek restrictions on imports of steel; and licensed electricians and doctors often lobby to keep regulations in place that restrict competition from unlicensed electricians or doctors 2. The idealistic view of public regulation is deeply embedded in professional economic thought. 3. So many economists, for example, have denounced the ICC for its pro-railroad policies that this has become a cliche of the literature. 4. The fundamental vice of such criticism is that it misdirects attention: it suggests that the way to get an ICC which is not subservient to the carriers is to preach to the commissioners or to the people who appoint the commissioners. 5. The only way to get a different commission would be to change the political support for the commission, and reward commissioners on a basis unrelated to their services to the carriers. 6. Until the basic logic of reform is developed, reformers will be ill-equipped to use the state for their reforms, and victims of the pervasive use of the state's support of special groups will be helpless to protect themselves.

Prepayment risk

1. Prepayment risk for MBS investors is the unexpected return of principal stemming from consumers who refinance the mortgages that back the securities. 2. Homeowners are more likely to refinance mortgages when interest rates are falling. 3. As this translates into prepayment of MBS principal, investors are often forced to reinvest the returned principal at a lower return. 4. CMOs accommodate the preference of investors to lower prepayment risk with classes of securities that offer principal repayment at varying speeds. The different bond classes are also called tranches (a French word meaning slice). Some tranches—CMOs can include 50 or more—can also be subordinate to other tranches. In the event loans in the underlying securitization pool default, investors in the subordinate tranche would have to absorb the loss first.

Beneficiaries of LOLR

1. Preserving a going concern does benefit management, workers and equity holders 2. But does not spare equity holders from costs of bad credit decisions 3. Largest benefits are to broader participants in the economy, even if they are spread around and not as visible

Fannie Mae: Regulatory failure

1. Private company built up immense market power 2. Failure left taxpayers with bill that is still to be counted 3. Collapse in September of 2008 was at the core of the financial crisis and ensuing global recession

GSEs

1. Privately held corporations with public purposes created by the U.S. Congress to reduce the cost of capital for certain borrowing sectors of the economy. Members of these sectors include students, farmers and homeowners. 2. GSEs carry the implicit backing of the U.S. Government, but they are not direct obligations of the U.S. Government. For this reason, these securities will offer a yield premium over Treasuries. Some consider GSEs to be stealth recipients of corporate welfare. 3. Freddie Mac and Fannie Mae are government-sponsored enterprises (GSEs).

Mosaic Theory

1. Professional investors make trading decisions based on the amalgamation of myriad pieces of information and data obtained from various sources and resources. 2. No single piece of information and data is material to the professional. 3. It is the review and analysis of the whole - the finished mosaic - that determines how the investor will proceed. 4. Query: What if one piece of information included in the mosaic is independently material?

Capital Ratios and Pre-crisis Prudential Regulation

1. Provided a buffer to absorb losses before an insurance fund had to pay out 2. Provided a buffer to comfort uninsured depositors 3. Because having low capital was thought to give a competitive advantage, the US sought international agreement on capital standards which resulted in Basel I in 1988 4. Do not take account of diversification and correlation (except in trading books under Basel II and III) 5. Have been strongly procyclical in implementation

"The Role of Finance in Economic Development: Benefits, Risks, and Politics" by Beck and Thorsten

1. Provides a balanced overview of economic research on the impact of financial markets on broad social objectives—economic growth and distribution 2. Section 1: 1) strong historical, theoretical, and empirical evidence for a positive role of financial deepening in the economic development process, 2) attempts made to reconcile the long-term positive effects of finance with the negative short-term effects of rapid credit growth, 3) recent evidence that financial sector deepening might actually have a negative effect on growth beyond a certain threshold has raised additional questions on the optimal size and resource allocation to the financial sector 3. Section 2: Recent financial crisis has 1) reignited interest in the competition-stability debate, 2) has shed doubts on risk measures, 3) has shown that runs can not only happen on the retail level 4) has also shown the urgent need for bridging the gap between macro- and financial economists 5) has also reignited the debate on the appropriate regulation of the financial system 6) policy solution that minimizes external effects of bank insolvency while at the same time enforcing market discipline is thus necessary, especially for SIFIs

Models of government

1. Public interest theory: A) Social welfare maximization, B) Pareto optimality 2. Theoretical sub-optimality of voting 3. Tyranny of the majority 4. Serves the interests only of those in government: Corruption driven 5. Private interest driven (public choice theory)

Fannie Mae: Lessons learned

1. Public private partnerships are dangerous: A) Confusion of objectives, B) Conflicts of interest, C) Breeds interlocking political and corporate power 2. Unintended consequences can be immense: A) Fannie was created in the form that wreaked havoc by legislation had the objective of hiding government debt

Legacy of CDOs

1. Regulatory changes responded to some of the problems that emerged: A) Basel 2.5 responded to the disparity in capital requirements on loans and securities, B) Regulatory oversight of ratings agencies tightened 2. Analytical practices in the market have changed in response to lessons learned 3. Market is beginning to recover

Regulatory Rules and Broader Supervision

1. Regulatory rules have long been complemented by broader supervision 2. e.g. the CAMEL(S) approach to "sup and reg"

Sources of failure relative to public interest ideal

1. Rent seeking (capture, threatened incumbents, money politics, revolving doors, small interconnected elite) 2. Unintended consequences of a well meaning policy 3. Lack of understanding on the part of legislators or regulators

Innovation to Boost Revenue

1. Respond to new needs (brokers' cash management accounts when interest rates rose) 2. Create new demands: e.g. buy side and sell side (Structured securities and high yield bonds)

Regulatory Response to S&Ls

1. Respond to pressure from S&L industry and their supporters 2. A sorry record of corruption: A) Keating Five--Alan Cranston, Don Riegle, Dennis Di Concini, John Glenn and John McCain--leaned on regulators on behalf of contributor, B) Jim Wright (Speaker of the House) resigned after, among other things, pressuring regulators on behalf of an S&L Silverado--Neil Bush, son of then Vice President George H W Bush was found by OTS to have breached fiduciary duties in failure of an S&L where he was a director

Good and bad interventions

1. Restrictions on short selling (e.g. US after Lehman collapse) 2. Market intervention (e.g. defending currency)

Problems Created by CDOs

1. Retail mortgage backed segment contributed to a boom and bust in housing 2. Market participants and the ratings agencies used models that were poorly designed and were supported with inadequate data 3. Distressed mortgage CDOs triggered a systemic collapse of liquidity, the failure of Lehman Brothers and the global financial crisis of 2008-2009 4. Other CDOs have performed reasonably well

Knight's Definition of Risk

1. Risk can be thought of as that which is subject to measurement by probability distributions and formal analysis 2. Amenable to mean variance analysis and its variants

Issues raised by large financial firms or financial supermarkets

1. Risk exposure of government to take loss: A) Relative to government capacity, B) Greater for large institutions than for an aggregate of small ones? 2. Misuse of information across business lines: Asset management or traders use of information about issuers 3. Incentive issues: A) Governance failure in large organizations, B) Cross subsidies 4. Capacity of management: Scale and breadth of management attention 5. Market power—size and linkages: Excessive market share or use of strong position in one market to gain business in another through linkage 7. The non-market power of size: A) Too big to fail and consequent moral hazard, B) Potential political influence

Conditions that a Lender of Last Resort (LoLR) is intended to respond to

1. Runs 2. Contagion 3. Panic

Legacy of S&Ls

1. S&L Industry shrank during crisis: A) Number declined from 3234 to 1545, B) Market share in home lending dropped from 54% to 30%, C) Survivors were more diversified financial institutions—a charter of convenience not distinguishable from consumer oriented banks, D) AIG Financial Products had an S&L license 2. Further marginalization under Dodd-Frank: A) No longer a separate thrift regulator, B) Incentives to convert to a bank charter

Tranche

1. The different bond classes are also called tranches (a French word meaning slice). 2. Some tranches—CMOs can include 50 or more—can also be subordinate to other tranches. 3. In the event loans in the underlying securitization pool default, investors in the subordinate tranche would have to absorb the loss first.

History of the Foreign Corrupt Practices Act

1. SEC began treating payments of bribes as a disclosure issue in the 1970s 2. Scandals (Lockheed bribes in Japan) in post Watergate reform environment led to passage of FCPA in 1977 SEC civil enforcement: A) DoJ criminal enforcement, B) 3. US campaigned for multilateral agreement and included G-7 support for OECD action in the communiques of the Lyon 1996 Summit: Lastly, we are resolved to combat corruption in international business transactions.... we urge that the OECD further examine the modalities and appropriate international instruments to facilitate criminalization and consider proposals for action in 1997. 4. OECD Convention took effect in 1999. Now has 40 signatories 5. US enforcement, which had not been very active, has been pursed aggressively since 2000.

Bernie Madoff's Ponzi Scheme: Regulatory failure

1. SEC received six substantive complaints about Madoff as early as 1992 2. The incentive to discover Madoff's secret and copy it motivated attention to the fund and led to whistleblowers: A) In 2000 Harry Markopolus raised issues with the SEC regarding Madoff's fund, B) Markopolus and others continued to raise questions with SEC and in the press, C) In 2005 Markopolus filed a detailed report with the SEC showing the virtual impossibility of Madoff's achieving the returns he reported 3. The SEC did a formal investigation and found no evidence of fraud

Factors that shape the policy environment

1. Sectoral involvement: A) Focused on finance--AML, B) Affects all sectors in similar ways—FCPA, C) Affect different sectors in different ways—Sanctions 2. Reach: A) Purely domestic—Community Development Domestic and international—AML, B) Purely international—FCPA 3. Implementing organization: A) Financially focused (FinCEN for AML and OFAC for sanctions at Treasury, B) SEC for FCPA, bank regulators for CRA), C) Non-financial focus (Justice when criminal penalties are involved)

Drivers of S&L Innovation

1. Secular rise in inflation and interest rates 2. Industry response that focused on legislative relief rather than innovation to respond to changing conditions 3. Missed opportunities: A) Earlier introduction of ARMS, B) Development of use of interest swaps to distribute interest rate risk

Specific issues with respect to breadth of powers

1. Securities and banking—for discussion session 2. Geography 3. Proprietary trading and banking (Volcker rule 4. Bancassurance 5. Commerce and banking

Securitization

1. Securitization is the creation and issuance of debt securities, or bonds, whose payments of principal and interest derive from cash flows generated by separate pools of assets. 2. It has grown from a non-existent industry in 1970 to $6.6 trillion as of the second quarter of 2003. Financial institutions and businesses of all kinds use securitization to immediately realize the value of a cash-producing asset. 3. These are typically financial assets such as loans, but can also be trade receivables or leases. In most cases, the originator of the asset anticipates a regular stream of payments. By pooling the assets together, the payment streams can be used to support interest and principal payments on debt securities. 4. When assets are securitized, the originator receives the payment stream as a lump sum rather than spread out over time. Securitized mortgages are known as mortgage-backed securities (MBS), while securitized assets—non-mortgage loans or assets with expected payment streams—are known as asset-backed securities (ABS).

Asset-Backed Securities (ABS)

1. Securitization is the creation and issuance of debt securities, or bonds, whose payments of principal and interest derive from cash flows generated by separate pools of assets. 2. It has grown from a non-existent industry in 1970 to $6.6 trillion as of the second quarter of 2003. Financial institutions and businesses of all kinds use securitization to immediately realize the value of a cash-producing asset. 3. These are typically financial assets such as loans, but can also be trade receivables or leases. In most cases, the originator of the asset anticipates a regular stream of payments. By pooling the assets together, the payment streams can be used to support interest and principal payments on debt securities. 4. When assets are securitized, the originator receives the payment stream as a lump sum rather than spread out over time. Securitized mortgages are known as mortgage-backed securities (MBS), while securitized assets—non-mortgage loans or assets with expected payment streams—are known as asset-backed securities (ABS). 5. The first asset-backed securities (ABS) date to 1985 when the Sperry Lease Finance Corporation created securities backed by its computer equipment leases. Leases, similar to loans, involve predictable cash flows. In the case of Sperry, the cash flow comes from payments made by the lessee. Sperry sold its rights to the lease payments to an SPV. Interests in the SPV were, in turn, sold to investors through an underwriter. 6. Since then, the market has grown and evolved to include the securitization of a variety of asset types, including auto loans, credit card receivables, home equity loans, manufactured housing loans, student loans and even future entertainment royalties. Credit card receivables, auto and home-equity loans make up about 60 percent of all ABS. Manufactured housing loans, student loans and equipment leases comprise most of the other ABS. And the industry continues to look for new assets to securitize such as auto leases, small-business loans and "stranded cost recovery" ABS. (The latter refers to bonds backed by fees some newly deregulated utilities have won authority to include in future billings as an offset of previous investment.)

"Statement on behalf of the American Securitization Forum" by Cameron Cowan

1. Securitization reflects innovation in the financial markets at its best. 2. Pooling assets and using the cash flows to back securities allows originators to unlock the value of illiquid assets and provide consumers lower borrowing costs at the same time. MBS and ABS securities offer investors with an array of high quality fixed-income products with attractive yields. The popularity of this market among issuers and investors has grown dramatically since its inception 30 years ago to $6.6 trillion in outstanding MBS/ABS today [2003]. 3. The success of the securitization industry has helped many individuals with subprime credit histories obtain credit. Securitization allows more subprime loans to be made because it provides lenders an efficient way to manage credit risk. 4. Efforts to curb "predatory" lending that inhibit the legitimate use of securitization by assigning liability to the purchaser of a loan or some other means, threaten the success of the beneficial subprime market. 5. Secondary market purchasers of loans, traders of securitized bonds and investors are not in a position to control origination practices loan-by-loan. 6. Regulation that seeks to place disproportionate responsibilities on the secondary market will only succeed in driving away the capital loan purchasers provide in the subprime market.

Commerce and Banking

1. Separated in the US 2. Combinations permitted in many other countries Historically especially strong in Japan 3. Does cause conflicts: A) Low return on investment in Japan has been attributed to close corporate bank links, B) Concern about risk taking—betting the bank to save the manufacturing company 4. Potential for concentration of economic, financial and political power 6. Gray area—Captive Finance Companies—GE Capital

Antitrust action in finance has not been aggressive in recent years

1. Should it be? 2. Areas of concern: A) Fees on credit card transactions charged to retailers (Retailer political pressure brought limits on debit cards in Dodd Frank. Price setting by the government is one way to deal with market power.), B) Concentration of MBS issuance may have given issuers market power over ratings agencies, C) Concentration of investment banking raises questions about client choice as well as market power. 3. Contestability as a source of market discipline is questionable in these sectors.

"Estimating the Costs of Financial Regulation" by Andre Oliveira Santos and Douglas Elliott

1. Shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term 2. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders' operating costs,affecting bank customers, employees, and investors 3. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy

Contagion and LOLR

1. Single institution loss of liquidity should be satisfied by the market 2. But it may be necessary to respond to the first liquidity problem to avoid others

Sources of failure relative to public interest ideal: Capacity and culture

1. Societies clearly have different governance capacities reflecting history: A) Education levels, B) Loyalties (to self, to family, to tribe, to state), C) Institutions—traditions, laws, organizations 2. International financial institutions have put immense stress on capacity building over the past 25 years: Success is debated, but importance is not 3. The policy approach should reflect capacity: Simple structures and rules where capacity is limited 4. Even the most developed governance capacity may fall short of what is needed for complex financial systems that would appear in the absence of restraint: Do we need to hold back financial development to keep it from getting too far ahead of government capacity?

"Study of the Effects of Size and Complexity of Financial Institutions on Capital Market Efficiency and Economic Growth" by Tim Geithner

1. Some studies examining the relationship between FI performance and FI size find that there are scale economies associated with large FIs. Large FIs disproportionately enjoy the efficiency gains from technological progress and the benefits associated with the ability to diversify risk. Strict limits on bank size therefore could pose a cost to large FIs, which are best positioned to accrue these benefits. Conversely, there are benefits to limiting FI size. Large FIs in concentrated markets may abuse their market power, leading to elevated credit prices that are socially inefficient. Limitations on the relative size of FIs may prevent high levels of concentration and the socially inefficient pricing of credit. Section 622 of the Dodd-Frank Act addresses this issue by imposing a concentration limit on the financial sector that prevents any FI from conducting a merger or acquisition that would result in the FI accounting for more than ten percent of the liabilities of the financial sector. Limiting FI size, together with other restrictions in the legislation, also may prevent FIs from growing so large that they are perceived by the market as "too big to fail." Limiting the perception that some FIs are "too big to fail" will constrain excessive risk taking by preventing the moral hazard associated with the perceived access to a government safety net. Moreover, limiting the relative size of any single financial firm will limit the adverse effects from the implosion of any single firm for reasons specific to that firm. 2. If diversification and organizational complexity have more costs than benefits in terms of more risky activities, lower capital and higher exposure to systemic risk, then limits on diversification could help enhance financial stability and economic growth. Although some findings are mixed, most of the empirical literature suggests that diversification and complexity expand the supply of financial services and reduce institutions' individual probability of failure, but at the same time shift institutions towards more risk-taking, increase the level of interconnectedness among financial firms, and therefore may increase systemic default risk. These potential costs may be exacerbated in cases where the market perceives diverse and complex financial institutions as "too big to fail," which may lead to excessive risk taking and concerns about moral hazard. The literature thus provides some support for limits on degree or scope of diversification and organizational complexity of large financial firms. That said, there may well be benefits of organizational complexity and diversification that are not yet addressed in the literature. In addition, it is important to note that little research exists on the effects of specific limits on diversification and organizational complexity (as opposed to research on the costs and benefits of diversification and organizational complexity themselves). 3. The separation of business units may expedite the resolution of a financial institution. A fast and efficient resolution regime can dampen loan supply shocks due to a failure of a financial institution. Efficient resolutions also enhance trust in the soundness of the financial system, which is crucial to the efficiency of capital markets. Market forces lead financial institutions to choose their organizational structure that maximizes efficiency. This sometimes leads to a separation of business units in order to reduce conflicts of interest. However, the separation of business units can reduce the firm's ability to centralize functions such as liquidity management, and can thus result in a reduction in economies of scale. Restrictions on the organizational structure of financial institutions might also distort the allocation of capital in the economy, increase tax liability, increase risk taking, and reduce overall capital market efficiency. Rajan and Zingales (1998) study the relationship between finance and growth and find that external finance-dependent industries grow slower in countries with less efficient capital markets. The literature on the separation of business units is sparse. 4. Restrictions on risk transfer can, in theory, have both positive and negative effects. The overall effect is likely to depend upon their specific implementation. Implicit recourse is a way for sponsors of SPVs to commit to not engaging in adverse selection through long-run reputational effects. Limits on implicit recourse would remove a form of contracting that is efficiency enhancing from the perspective of individual firms, and would likely prevent certain types of asset sales from occurring. The cost of obtaining funds would rise for some sponsoring firms, such as originators of riskier assets for which private information plays a larger role. Whether or not preventing such deals from occurring is beneficial for the economy as a whole deserves further study. Implicit recourse may allow firms to circumvent capital regulations and take on more risk than they are charged for through capital requirements. Restrictions on such risk transfers may limit banks' ability to exploit the government safety net. However, an argument against limiting regulatory arbitrage is that doing so would, at least in theory, prevent firms from avoiding capital requirements that could be inefficiently high. Limits on risk transfer among consolidated business units would reduce the ability of firms to use enterprise-wide risk management. Firms would most likely be forced to adopt a more balkanized, and potentially costlier, approach to internal capital allocation. Restrictions on risk transfer may also reduce the efficient use of "natural" hedges generated by activities at different business units, forcing individual business units to seek outside sources of hedging at a higher overall cost. Firms may also have a reduced incentive to identify the true shadow cost of each business unit's activities to overall riskiness of the firm. The above arguments must be tempered by the consideration that, in practice, internal capital allocation mechanisms may not adequately account for all the different types of risk that a firm may face. If not, then the firm's internal market for capital may not be an effective way to manage risk. Moreover, perverse managerial incentives may lead to cash flow hoarding that shields inefficient projects from scrutiny. Each of these factors would tend to reduce the costliness of limiting risk transfers. Section 941 of the Dodd-Frank Act addresses adverse selection by requiring securitizers to retain a share of the credit risk of transferred assets. However, Section 941 leaves great discretion to regulators to implement this requirement. Regulators will determine the amount of risk securitizers will retain, the form(s) in which they may retain it, and other critical elements. The regulators are still in the process of formulating a proposed regulation for comment. The Chair of the FSOC is coordinating the rulemaking process, as required by Section 941. 5. The benefits and costs of contingent capital and similar mechanisms for financial firms and the wider economy will critically depend on the specific features of the contracts—what kind of structure is employed (e.g. debt-to-equity swap or insurance contract), what type of trigger is used (e.g. firm-specific or systemic), and what threshold is set for actions such as a recapitalization through a cash injection or a debt write-down. Such features will affect how frequently recapitalization or other actions take place and whether the mechanism achieves the desired results (e.g. greater market discipline, more stable credit, greater loss absorption capacity through larger capital buffers, and less systemic risk). Equally important for cost-benefit analysis are the tax, legal, and regulatory frameworks in place over the life of the contract. On the benefit side, much of the academic literature has focused on the potential for contingent capital to (1) reduce systemic risk; (2) augment market discipline on systemically-important financial institutions; (3) reduce incentives to shift activities to unregulated firms during boom times; (4) align private costs with the social costs associated with systemic risks through privately-provided "tail-risk" insurance; and (5) provide incentives for systemically-important firms to raise capital when they anticipate losses. It is unclear to what extent these benefits could be realized in practice. With regard to potential costs, much of the academic literature has focused on whether specific contingent capital contracts would result in unfavorable market dynamics, such as "death spirals" or a "run" on financial firms with similar exposures. Another concern addressed by the literature is that debt-to-equity conversions or other actions to recapitalize a firm could be taken too early or too late. For example, a financial institution may remain subject to a "run" by short-term liability holders even if it has buffer of contingent capital in place, because such investors may perceive that capitalization will remain thin enough after the triggering event to encourage the management to "bet-the-bank" by taking on excessive risk. Importantly, some recent research has used back-testing to explore the performance of various contingent capital mechanisms. 6. The literature identifies several clear benefits that arise from the separation of banking and commerce. Separation of banking and commerce may prevent conflicts of interest that would undermine the independence and neutrality of banks in the allocation of credit. Separation may also prevent market power distortions that might arise from the cross-subsidization of commercial and financial products within large conglomerates. If such market power were used inappropriately, it could result in traditional banks being priced out of certain financial services. Separation would also prevent the transfer of risk from commercial firms to banking affiliates or an unintentional expansion of the federal safety net. The literature also identifies potential costs of limiting the mixing of banking and commerce. These costs could include reduced supply and increased cost of credit. Separation of banking and commerce could reduce technological efficiency by reducing the economies of scope that come from cross-selling and "one-stop shopping." For example, fixed costs of collecting, processing and assessing information can be spread across a range of commercial and financial services, such as a payments system internal to the commercial entity. Separation of banking and commerce could also prevent a bank from diversifying its earnings with multiple income streams. Empirical studies of both the benefits and costs, however, are limited. 7. The limited literature on combining traditional banking and nontraditional higher-risk operations does not support either strict separation or unrestricted mixing. Some researchers find that allowing banks to engage in nontraditional financial activities appears to have been socially beneficial. Other researchers find that removing the barriers separating bank and nonbanks appears to have increased systemic risk. In many cases, however, the evidence concerning segregation of banking and nonbanking financial activities is still quite limited, suggesting a robust agenda for future research.

"Regulation and Failure" by Joseph Stiglitz

1. Stiglitz outlines the market-failure approach to reform, with especial application to the financial sector 2. Over the past two hundred years, economic theory and historical experience has shown that financial markets often fail to perform their essential functions of managing risk and allocating capital well, with disastrous social and economic consequences. 3. Finance is a means to an end, not an end in itself 4. A good financial sector would have used few of society's resources; in a competitive financial sector, profits would have been low 5. Our financial sector was large, and it garnered a third of corporate profits

Random walk tests and implications

1. Stock market prices have been shown to be very close to random walks 2. Exchange rates have not passed efficiency tests 3. Those without information are not disadvantaged in markets if many others have it—buy and hold index investing is efficient (but a little knowledge could be a dangerous thing) 4. Despite near random walks which suggest that it is very hard if not impossible to profit from better use of information, excess volatility and apparent bubbles raise questions about efficiency

"The Incentive Bubble" by Mihir Desai

1. Stock-based pay and high-powered incentives contracts have evolved in a pathological direction 2. Compensation pegged to the financial markets has rewarded luck and encouraged a short-term focus 3. Hedge funds and private equity funds first to use this kind of compensation system and big banks used it to attract talent

What counts as capital?

1. Subordinated debt as good as equity 2. Market going to push down price of subordinated debt in bad times, whereas equity holders want bank to take more risk 3. Subordinated debt doesn't deal with limited liability problem.

"Pubic Choice Theory" by Wikipedia

1. Subset of positive political theory that models voters, politicians, and bureaucrats as mainly self-interested 2. As Shafer notes, a fair characterization of reality, but not a complete guide to behavior of someone with public responsibilities 3. Ethics, reputation and future career all enter into the thinking of even strongly self interested officials.

Some segments have clear commercial synergies

1. Synergies on client side: A) Whom one talks to and interconnectedness of client decisions, B) Corporate lending, C) Securities origination, D) Strategic advice (M&A) 2. Convenience and knowing ones customer: A) Consumer deposit taking, B) Consumer lending, C) Wealth management 3. Synergies on the production side: A) parallel functions—portfolio management, B) Insurance, C) Asset Management 4. Complementary functions—use market knowledge: A) Capital markets origination, B) Sales and trading

Do we need a Capital Provider of Last Resort? (CPoLR)

1. TARP could be seen this way 2. Should this also be restricted to institutions judged to be solvent? 3. What conditions would be appropriate

Policies to limit or reshape compensation in the United States after the crisis

1. TARP implementation: A) Oversight of compensation of top officers of receiving institutions B) Treasury imposed cap of $500,000 on compensation of top executives of firms receiving exceptional assistance (AIG, Citigroup, Bank of America) as long as debt was outstanding 2. Dodd Frank (all sectors): A) Established "say on pay" giving shareholders a nonbinding vote on executive pay B) Called for SEC to establish rules on independence of board compensation committees and advisors

"Ending 'Too Big to Fail': A Proposal for Reform Before It's Too Late (With Reference to Patrick Henry, Complexity and Reality)" by Richard Fisher

1. TBTF institutions, as a result of their privileged status, exact an unfair tax upon the American people. Moreover, they interfere with the transmission of monetary policy and inhibit the advancement of our nation's economic prosperity. 2. Everyone and their sister knows that financial institutions deemed too big to fail were at the epicenter of the 2007-09 financial crisis. Sick banks don't lend. Sick—seriously undercapitalized—megabanks stopped their lending and capital market activities during the crisis and economic recovery. They brought economic growth to a standstill and spread their sickness to the rest of the banking system. 3. The Dallas Fed's definition [of TBTF] is financial firms whose owners, managers and customers believe themselves to be exempt from the processes of bankruptcy and creative destruction. Such firms capture the financial upside of their actions but largely avoid payment—bankruptcy and closure—for actions gone wrong, in violation of one of the basic tenets of market capitalism. Such firms enjoy subsidies relative to their non-TBTF competitors. They are thus more likely to take greater risks in search of profits, protected by the presumption that bankruptcy is a highly unlikely outcome. 4. Recommends that TBTF financial institutions be restructured into multiple business entities. Only the resulting downsized commercial banking operations—and not shadow banking affiliates or the parent company—would benefit from the safety net of federal deposit insurance and access to the Federal Reserve's discount window. 5. The remaining group, the megabanks—with assets of between $250 billion and $2.3 trillion—was made up of a mere 12 institutions. These dozen behemoths accounted for roughly 0.2 percent of all banks, but they held 69 percent of industry assets. 6. TBTF megabanks receive far too little regulatory and market discipline. This is unfortunate because their failure, if it were allowed, could disrupt financial markets and the economy. For all intents and purposes, we believe that TBTF banks have not been allowed to fail outright. Knowing this, the management of TBTF banks can, to a large extent, choose to resist the advice and guidance of their bank supervisors' efforts to impose regulatory discipline. And for TBTF banks, the forces of market discipline from shareholders and unsecured creditors are limited. 7. It calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking. Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support.

Sanctions on Russia and Russian individuals will be a new test

1. Targeting of Specially Designated Nationals is a relatively new feature: A) will hurting Putin's friends have more impact than hurting Russia?, B) Oligarch wealth creates a target 2. Participation of other countries remains in doubt: A) Effectiveness is one risk, B) US role in global financial system is another

"Corporate Governance and Banks: What Have We Learned from the Financial Crisis?" by Hamid Mehran, Alan Morrison and Joel Shapiro

1. Thanks to the deposit insurance subsidy, shareholders in banks have created incentives for taking risks and maximizing leverage, at a substantial cost to other stakeholders 2. This effect has been amplified in recent years as banks have been able to push into newer, more complex activities and have thus broadened their scope 3. The nature of these businesses has made it difficult for regulators to keep pace with the changes and analyze the implications of the expansion

Implications of Arrow-Debreu Model

1. That such an equilibrium could exist under the assumptions was shown by Arrow and Debreu 2. An equilibrium is Pareto efficient (allocatively efficient) 3. Key conditions highlight potential problems: 1) Rational decision making maximizing expected utility, 2) complete markets, 3) costless information equally available, 4) no transactions costs, 5) market clearing, 6) all market participants are price takers—competitive markets 7) future generations must be able to participate in the market 4. Arrow Debreu model has driven innovation to move closer to its conditions (especially market completeness) and to make a case for deregulation

Basel Committee

1. The Basel Committee on Banking Supervision (the BCBS or the Basel Committee) was formed in 1974 to advise national financial regulators on common capital requirements for internationally active banks

"Federal Credit and Insurance Programs: Housing" by James Quigley

1. The Federal Housing Administration (FHA), Veterans Administration, Federal National Mortgage Association, and Federal Home Loan Mortgage Corporation have played major roles in the development of liberal and efficient primary and secondary mortgage markets in the United States. 2. The development of capacity in mortgage lending and securitization in the private sector does suggest, however, that federally subsidizing mortgage market activities can be restrained with little effect on homeownership—the principal goal of this federal activity. 3. In particular, the orderly reduction in the mortgage investment activities of the government-sponsored enterprises (GSEs) and the imposition of guarantee fees on mortgage-backed securities insured by the GSEs are first steps in restraining federal activity. 4. More generally, a concentration of FHA and GSE activity on first-time homebuyers would reduce federal risk exposure while preserving the economic rationale for government activity.

Financial Action Task Force (FATF)

1. The Financial Action Task Force (FATF) is an inter-governmental body established in 1989 by the Ministers of its Member jurisdictions. The objectives of the FATF are to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system. The FATF is therefore a "policy-making body" which works to generate the necessary political will to bring about national legislative and regulatory reforms in these areas. 2. The FATF has developed a series of Recommendations that are recognised as the international standard for combating of money laundering and the financing of terrorism and proliferation of weapons of mass destruction. They form the basis for a co-ordinated response to these threats to the integrity of the financial system and help ensure a level playing field. First issued in 1990, the FATF Recommendations were revised in 1996, 2001, 2003 and most recently in 2012 to ensure that they remain up to date and relevant, and they are intended to be of universal application. 3. The FATF monitors the progress of its members in implementing necessary measures, reviews money laundering and terrorist financing techniques and counter-measures, and promotes the adoption and implementation of appropriate measures globally. In collaboration with other international stakeholders, the FATF works to identify national-level vulnerabilities with the aim of protecting the international financial system from misuse.

McFadden Act

1. The McFadden Act of 1927 was one of the most hotly contested pieces of legislation in U.S. banking history, and its influence was still felt over half a century later. 2. The act was intended to force states to accord the same branching rights to national banks as they accorded to state banks. 3. By uniting the interests of large state and national banks, it also had the potential to expand the number of states that allowed branching. 4. Congressional votes for the act therefore could reflect the strength of various interests in the district for expanded banking competition. 5. Unlike previous work, Rajan andRamcharan find strong evidence of elite influence 6. Find that congressmen in districts in which landholdings were concentrated (suggesting a landed elite), and where the cost of bank credit was high and its availability limited (suggesting limited banking competition and high potential rents), were significantly more likely to oppose the act. 7. The evidence suggests that while the law and the overall regulatory structure can shape the financial system far into the future, they themselves are likely to be shaped by well organized elites, even in countries with benign political institutions.

Galleon Case

1. The SEC has charged 35 defendants trading in the securities of 15 companies generating illicit profits of more than $96 million. A total of 34 defendants have settled the SEC's charges. The illegal conduct involved Raj Rajaratnam and his New York-based hedge fund Galleon Management making cash payments in exchange for material non-public information. The case eventually ensnared corporate executives, consultants, rating agency personnel, proprietary traders, hedge fund executives, and public relations personnel. 2. Raj Rajaratnam, co-founder of the hedge fund Galleon Group, made millions of dollars in illegal profits by trading on tips about companies like Intel Corp., Goldman Sachs and Clearwire Corp. Intel executive Rajiv Goel pleaded guilty to leaking information to Mr. Rajaratnam about Clearwire that he learned at Intel. The government alleges that Mr. Rajaratnam made about $579,000 trading on this information, and that he "paid" for the tips by placing profitable trades for Mr. Goel's benefit in a private brokerage account. Paying for confidential corporate information is and should be illegal because it is improper to bribe an executive to betray his duty of confidence to his employer. However, some of the government's other allegations accuse Mr. Rajaratnam of simply talking to people and then trading. But if the information did not come from an insider, or if it was being relayed for a legitimate corporate purpose such as to set the record straight about the company, then it is not illegal.

US efforts to extend reach extraterritorially--financial sector gives some leverage

1. US financial sanctions on North Korea seemed to have got some response, more than anything else we have done, given their effectiveness in blocking use of dollars Justice Department threatening criminal action against 2. Credit Suisse and BNP Paribas for violations of US Iran sanctions 3. But impact comes at a cost in stimulating competitive alternatives: Hong Kong banks seeking displaced Russian business

Trust

1. The SPV can either be a trust, corporation or form of partnership set up specifically to purchase the originator's assets and act as a conduit for the payment flows. 2. Payments advanced by the originators are forwarded to investors according to the terms of the specific securities. 3. In some securitizations, the SPV serves only to collect the assets which are then transferred to another entity—usually a trust—and repackaged into securities. Individuals are appointed to oversee the issuing SPV or trust and protect the investors' interests. 4. The originator, however, is still considered the sponsor of the pool.

"The American Mortgage in Historical and International Context" by Richard Green and Susan Wachter

1. The U.S. mortgage before the 1930s would be nearly unrecognizable today: it featured variable interest rates, high down payments and short maturities. Before the Great Depression, homeowners typically renegotiated their loans every year. 2. The U.S. mortgage provides many more options to borrowers than are commonly provided elsewhere: American homebuyers can choose whether to pay a fixed or floating rate of interest; they can lock in their interest rate in between the time they apply for the mortgage and the time they purchase their house; they can choose the time at which the mortgage rate resets; they can choose the term and the amortization period; they can prepay freely; and they can generally borrow against home equity freely. They can also obtain home mortgages at attractive terms with very low down payments. 3. The unique characteristics of the U.S. mortgage provide substantial benefits for American homeowners and the overall stability of the economy. 4. The home mortgages available to borrowers in the United States have evolved over time into a broadly available menu of choices that is not available anywhere else in the world. 5. This menu of choices for the overwhelming majority of borrowers is possible because the U.S. mortgage system—with the implicit government guarantee for Fannie Mae and Freddie Mac—has solved the problem of how to persuade low-risk borrowers to join with higher-risk borrowers in broad mortgage pools, which provide the basis for mortgage-backed securities which can then be sliced up in financial markets. 6. But the benefits to mortgage borrowers come with their own set of risks: namely, the risk that Fannie Mae and Freddie Mac will malfunction in a way that will either cost the federal government a lot of money, or lead to a systematic crisis in U.S. financial markets, or both. This risk is real. 7. But the benefits from the current U.S. system of mortgage finance for borrowers and macroeconomic stability are also real and should not be lightly discarded.

Comparative Financial Regulatory Structures

1. The US has a mess that is a mix of institutional and functional elements 2. The UK put in place a unitary regulator but have taken it apart after the crisis 3.Australia has moved down the objectives path

Geography

1. The US has historically been very restrictive about bank branching: A) Across state lines (banned by McFadden Act in 1927, but wasn't done much if at all before then), B) Many states did not allow branch banking at all (Illinois from 1870; relaxation began in 1976, free branching in 1993) 2. Reflected the regionalism of US politics--countryside against the big Eastern cities 3. Protected local interests 4. Economically costly—inefficient, many failures with concentrated

Origination

1. The assets used in securitizations are created—or originated—in a number of ways. 2. When a lender extends a loan or acquires another revenue-producing asset such as a lease, they are creating assets that can be securitized. 3. Other assets, such as the balances due on credit card accounts or a corporation's accounts receivable can also be securitized. 4. Because they initiate the securitization chain, the lenders, credit card companies and others are also called originators. 5. Originators often retain a connection to their assets following a securitization by acting as a servicer—the agent collecting regular loan or lease payments and forwarding them to the SPV. Servicers are paid a fee for their work. Some originators contract with other organizations to perform the servicing function, or sell the servicing rights

Relationship between Liquidity Crises and Bubbles

1. The bankruptcy of the Penn Central Railroad in 1970 triggered a collapse in the commercial paper market was not preceded by a bubble, but there were other elements that stressed market generated liquidity, as the new market that was untested and there was Rapid growth in the new instrument 2. A single company shock produced contagion 3. The fallout was contained by Federal Reserve action as lender of last resort

"Managing Crises in the Emerging Financial Landscape" by Jeffrey Shafer

1. The broad conclusion is that the emerging financial system seems less vulnerable than the systems of the past to the kind of financial crises that the lender of last resort is meant to deal with -namely, a threat of widespread illiquidity among solvent depository institutions 2. Nevertheless, the financial system remains vulnerable to certain types of crises, and perhaps more so than in the past. 2. This conclusion points to the need for policies to reduce tendencies for stress to build up in the financial system - that is, policies must be geared to prevention. Stronger authority for supervisors to step in at an early stage may also be needed if isolated problems are to be kept from building into systemic ones

"U.S. Implementation of the Basel Capital Regulatory Framework" by Darryl Getter

1. The call for higher capital requirements on the banking system could arguably translate into more expensive bank credit for borrowers or even decline 2. Prior to the financial crisis, banks maintained capital levels that exceeded the minimum regulatory requirements and the economy still saw widespread lending 3. Bank capital reserves may not have been an effective financial risk mitigation tool especially given that a significant amount of lending took place outside of the regulated banking system 4. Bank capital may grow more effective at mitigating lending risks in the economy given that lending from non-bank sectors has since diminished, but credit availability may also become more contingent upon the transition to the higher capitalization levels

"The Flight from Maturity" by Gary Gorton, Andrew Metrick and Lei Xie

1. The crisis was an ongoing build-up of fragility starting before August 2007 and continuing, finally resulting in the Lehman failure, in effect caused by this build-up of fragility 2. The build-up was the result of market participants trying to recreate moneyness by, among other things, shortening maturities 3. A crisis is a dynamic process in which "shocks" are to an important extent endogenous

Bank capital

1. The difference between the value of a bank's assets and its liabilities. The bank capital represents the net worth of the bank or its value to investors. The asset portion of a bank's capital includes cash, government securities and interest-earning loans like mortgages, letters of credit and inter-bank loans. The liabilities section of a bank's capital includes loan-loss reserves and any debt it owes. 2. A bank's capital can be thought of as the margin to which creditors are covered if a bank liquidates its assets. Loan-loss reserves or loan-loss provisions, are amounts set aside by banks to allow for any loss in the value of the loans they have offered.

"The Wild Ride of Mortgage-Backed Securities" by Stephen Roth

1. The final chapters of the August 2007 collapse of the mortgage industry have yet to be played out. 2. Thousands of individuals and families will lose their homes due to foreclosures caused by the credit crunch that the United States is now experiencing— real people, real families, with the rug of the American dream of home ownership pulled out from underneath them. 3. So, you can't blame this one on Lew Ranieri. It was five long years of greed ruling over fear (and now there will probably be at least six months of fear ruling over greed). 4. Many people have a share of the blame. Borrowers who borrowed the full value of their home with little likelihood of making the interest payments can be blamed.Mortgage companies with a desire to originate and sell off subprime mortgages to Wall Street can be blamed. Wall Street firms, of course, are also to blame. They are in the middle—as they always are—caught between the mortgage firms and the investors who were willing to snap up poor-quality, subprime mortgage loan securities. And the investors also share in the blame, those who ignored prudent credit standards and bought these securities at yields that were nowhere close to compensating them for the risk. 5. There is more blame to go around.The rating agencies, Standard & Poor's and Moody's, are to blame for rating junk securities as investment-grade. And we cannot forget the regulators, including the state regulators who oversee mortgage firms, as well as the federal regulators, including the FDIC, the Office of the Comptroller of the Currency, and the Federal Reserve Board, which continued to feed this feeding frenzy with easy money and only in spring 2007 began to warn of lax lending by the banks. 6. And then one day, the fear will fade and the greed will return. It will be back to business as usual.

"Behaviorally Informed Financial Services Regulation" by Michael Barr, Sendhil Mullainathan, and Eldar Shafir

1. The financial services system is exceedingly complicated and often not well-designed to optimize household behavior. In response to the complexity of our financial system, there has been a long-running debate about the appropriate role and form of regulation. Regulation is largely stuck in two competing models—disclosure, and usury or product restrictions. 2. Explores a different approach, based on insights from behavioral economics on the one hand, and an understanding of industrial organization on the other. Crux is the interaction between individual psychology and market competition. 3. Adopts a behavioral economic framework that considers firm incentives to respond to regulation. Outcomes are an equilibrium interaction between individuals with specific psychologies and firms that respond to those psychologies within specific market contexts. Regulation must then address failures in this equilibrium. The model suggests, for example, that in some contexts market participants seek to overcome common human failings (as for example, with under-saving) while in other contexts market participants seek to exploit these failings (as for example, with over-borrowing). Behaviorally informed regulation needs to take account of these different contexts. 4. The paper discusses the specific application of these forces to the case of mortgage, credit card, and banking markets. The purpose of this paper is not to champion policies, but to illustrate how a behaviorally informed regulatory analysis would lead to a deeper understanding of the costs and benefits of specific policies. To further that understanding, in particular, the paper discusses ten ideas: • Full information disclosure to debias home mortgage borrowers. • A new standard for truth in lending. • A "sticky" opt-out home mortgage system. • Restructuring the relationship between brokers and borrowers. • Using framing and salience to improve credit card disclosures. • An opt-out payment plan for credit cards. • An opt-out credit card. • Regulating of credit card late fees. • A tax credit for banks offering safe and affordable accounts. • An opt-out bank account for tax refunds.

"Understanding Regulation" by Andrei Shleifer

1. The framework presented here allows for a comparative analysis of institutions from the perspective of the trade-off between dictatorship and disorder. 2. This trade-off looks different for different countries, and even for different activities within a country. 3. This trade-off can help organize the analysis of efficient institutional choice, which recognizes both the needs of a particular environment, and the constraints imposed by a country's political structure and institutional tradition. 4. This framework is applied to the example of regulation of securities markets, and argues that private enforcement of public rules may emerge as an efficient strategy of social control of these markets. 5. Some empirical evidence assembled is broadly consistent with this point of view.

CAPM in practice

1. The fundamental tool of Wall Street portfolio and risk management 2. Many elaborations, variations and refinements but it is the view of the world that permeates the markets 3. Use relies on past variances and correlations holding in the future

"The Theory of Economic Regulation" by George Stigler

1. The idealistic view of public regulation is deeply embedded in professional economic thought. 2. So many economists, for example, have denounced the ICC for its pro-railroad policies that this has become a cliche of the literature. 3. The fundamental vice of such criticism is that it misdirects attention: it suggests that the way to get an ICC which is not subservient to the carriers is to preach to the commissioners or to the people who appoint the commissioners. 4. The only way to get a different commission would be to change the political support for the commission, and reward commissioners on a basis unrelated to their services to the carriers. 5. Until the basic logic of reform is developed, reformers will be ill-equipped to use the state for their reforms, and victims of the pervasive use of the state's support of special groups will be helpless to protect themselves.

The JP Morgan case does show a need for care (the first FCPA case involving a financial institution)

1. The investment bank hired the son of the chairman of the China Everbright Group, a China state-controlled conglomerate, and won business from the group that included a stock offering by a subsidiary 2. JP Morgan's Hong Kong office also hired the daughter of a Chinese railway official. The bank went on to help China Railway raise more than $5 billion in its 2007 IPO 3. These hires were part of a "Sons and Daughters" program with "a spreadsheet that linked appointments to specific deals pursued by the bank." 4. JP Morgan also aid $1.8 million to a consulting firm run by then premier Wen Jia Bao's daughter 5. Emails suggest Jamie Dimon was asked by a senior Chinese regulator that JP Morgan hire a young family friend, whom he had brought to a meeting as a translator. She was hired; reported to be well qualified; Dimon claims not to have been involved in hiring decision

Margin Spiral

1. The margin/haircut spiral reinforces the loss spiral 2. As margins or haircuts rise, the investor has to sell even more because the investor needs to reduce its leverage ratio (which was held constant in the loss spiral). Margins and haircuts spike in times of large price drops, leading to a general tightening of lending 3. A vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria. Adrian ("Deciphering the Liquidity and Credit Crunch 2007-2008" by Markus Brunnermeier)

Capital Asset Pricing Model (CAPM)

1. Underlying idea is that agents will accept only increased risk for increased rates of return 2. CAPM attempts to place a price on increased risk and show that the market will only place a price on market risk 3. In an efficient market, all diversifiable risk will be diversified away

"The Optimal Regulatory Structure" by The Department of The Treasury

1. The market stability regulator should be responsible for overall conditions of financial market stability that could impact the real economy 2. The prudential financial regulator should focus on financial institutions with some type of explicit government guarantees associated with their business operations. 3. The business conduct regulator should be responsible for business conduct regulation across all types of financial firms. 4. The corporate finance regulator should be responsible for general issues related to corporate oversight in public securities markets

Liquidity and Policy

1. The objective of monetary policy is to regulate liquidity conditions in the economy in normal times (for other courses) 2. Supervision and regulation of financial institutions and markets shapes the availability and cost of liquidity to different actors (with efficiency and distributional implications), but its focus has been more on the institution than the system 3. Financial regulation also shapes the stability of liquidity generated in markets--neglected before the crisis (also next week) 4. Lender of last resort policy is the response to systemic liquidity threats or collapses 5. The stakes involved in assuring appropriate and stable liquidity dominate anything else in finance and public policy

"Social Welfare Function" by Wikipedia

1. The objective of the policymaker (a benign dictator) is to maximize a welfare function that is a sum of the utilities of the individuals in society 2. Does society include everyone? With the same weight? Future generations? Future immigrants? 3. Are there global responsibilities and/or expectations?

"Lewis S. Ranieri: Your Mortgage Was His Bond" by Bloomberg Businessweek

1. The past quarter-century has seen a revolution in finance. 2. It's felt every time a homeowner refinances a mortgage or signs up for a credit card. No one person can claim to have lit the fuse for this revolution -- but Lewis S. Ranieri was holding the match. Joining Salomon Brothers' new mortgage-trading desk in the late 1970s, the college dropout became the father of "securitization," a word he coined for converting home loans into bonds that could be sold anywhere in the world. 3. What Ranieri calls "the alchemy" lifted financial constraints on the American dream, created a template for cutting costs on everything from credit cards to Third World debt -- and launched a multibillion-dollar industry.

General Compensation issues

1. The principal agent problem 2. Multiple stakeholder issues 3. Is finance different from other businesses?

What the public wants

1. The public cares about economic stability. 2. After a financial crisis, a desire to punish those thought to be responsible may compete in public thinking with restoring stability and building a stronger system. 3. Distributional impacts may mobilize powerful groups (including the industry) 4. Governments must be concerned about how a transaction will be seen as well as the actual outcome.

Beta of an asset

1. The responsiveness of the security to the market 2. Measures the sensitivity of the return on security i to the return in the market as a whole 3. If beta = 1, asset moves just as market does 4. If beta > 1, moves more than the market does and thus have a higher return than the market (assuming alpha = 0) 5. If beta < 1, should have a lower return than the market (assuming alpha = 0)

Counterparty risk

1. The risk to each party of a contract that the counterparty will not live up to its contractual obligation 2. Counterparty risk as a risk to both parties and should be considered when evaluating a contract 3. Also known as "default risk" 4. E.g. Mike might default on the loan and not pay Joe back or Joe might stop providing the agreed upon funds

"Interaction of Financial and Regulatory Innovation" by Edward Kane

1. The strength of a dialectical vision is the evolutionary perspective it gives us for confronting and interpreting change. The regulatory dialectic has two policy implications. 2. First, in the face of exogenous changes in technology and economic volatility, rooting policies in concepts of stationary equilibrium is unreliable. Even if (as U.S. authorities desperately wish) a global cartel in financial regulatory services were successfully to be negotiated, the cartel would contain the seeds of its own future destruction. 2. Second, the problems being experienced by any set of regulatees and regulators is rooted in the detailed history of their prior conflict. For this reason, would-be regulatory reformers need to look beyond immediate problems to assess the long-run consequences of the policies they wish to install. 3. The regulatory dialectic emphasizes that, in the long run (by which is meant a period long enough that adjustment and information- acquisition costs become irrelevant), survivable patterns of regulation must be economically efficient ones. But even though the invisible hand eventually punishes over and under-regulators alike, in real time the process can produce considerable turmoil. The sequential search for efficiency can take a long time to unfold and can impose substantial pain of FSFs, their customers, and the general taxpayer. 4. From the point of view of their regulatees, revenue losses imposed by regulators' explicit charges and various operational constraints reduce the net value of the regulatory services received. We may define the balance between the costs and benefits that a given regulator succeeds in imposing on its regulatees as their net regulatory "burden" (or subsidy). The regulatory dialectic posits a dynamic adjustment process that in the long run enforces a "law of one regulatory burden." Precisely because inefficient patterns of regulation impose excessively burdensome costs either on regulatees, their customers, or the general taxpayer, the burdened parties must be expected sooner or later to develop avoidance strategies by which to throw these burdens aside. However, the more effectively a given set of regulators can hide the financial burdens from those who ultimately bear them, the longer it will take for effective avoidance strategies to come into play. 5. The variable nature of burden discovery and avoidance lags clarifies both what can go wrong in regulatory competition and why it is nevertheless a mistake to view rivalry among alternative regulators for clients and budgets merely as wasteful duplication. A monopoly supplier or regulatory cartel would tend in the short run to overregulation. When burden-bearers and elected politicians are well-informed, overlaps in regulatory missions across different regulatory entities promote short- and long-run efficiency in the production and delivery of regulatory services, much as duplication of service functions across private institutions promotes efficiency in the provision of financial services. However, when a regulator and its clients can exploit and perpetuate impediments in burden-bearers' access to the information needed to judge the regulator's performance, this competition can temporarily promote inefficiency instead. In the short run, inappropriately monitored regulators can deliver unintended and economically inappropriate subsidies. Only when the burden-bearers find a way to enforce their interest in preventing subsidies from being hidden, can we say that interregulator rivalry protects borrowers, depositors, and investors from the short-run as well as the long-run dangers of underregulation. 6. Some U.S. authorities are currently working very hard to prolong underpriced and misadministered deposit-insurance guarantees, selected restrictions on deposit-institution interest rates and product lines, and vestigial prohibitions against interstate banking. These efforts to prolong inefficient patterns of financial regulation help to conceal subsidies to risk bearing that increase economic volatility and threaten to disrupt world financial stability in the short run.

Insiders

1. The traditional insiders have been identified as members of management who possess information not readily available to the general public and who trade on that information to their own (or limited others') benefit. The Securities and Exchange Commission (SEC) defines the insider as a stockholder, director, or officer holding 10% of a company's voting common stock or the recipient of any unlawful disclosure [section 16(b) of the Securities Exchange Act of 1934]. 2. The headlines of the past few years have often focused on the unlawful recipients of inside information from the traditional insiders. These information recipients can be divided into two new categories of insider trader: The "quasi insider", and the "intermediary insider". 3. The quasi-insider is the individual who is responsible for carrying out some detail of a transaction that will potentially affect an entity's share price, and who shares in private information about the transaction as a result (Attorneys, CPAs). 4. Information intermediaries provide at least three services: private information search, prospective analysis, and retrospective analysis. Private information searching involves the intermediary's attempt to garner information that is unknown to the market as a whole. Prospective analyses are predictions as to what trends investors can expect in the market as a whole, some subset of the market, or an individual stock. Retrospective analyses provide historical data and comparisons to aid in decision making. The information intermediary can become an intermediary insider trader only when providing the private information search function. In general, the private information search function also involves legitimate research techniques such as informal discussion with company management about earnings forecasts.

Limiting size to limit taxpayer risk has in recent years become a serious policy concern

1. Three cases of countries with sound government finance brought down by banks: A) Iceland (bank assets 980% of GDP), B) Ireland (bank assets 440% of GDP), C) Cyprus (bank assets 800% of GDP), D) The US is a bit less than 100% and is less concentrated than these countries 2. Does not look like a serious risk in the US 3. Switzerland (483% in 2009), the Netherlands (462% in 2011) and the UK (535% in 2011) are different cases. More a problem of an oversize the banking system built on international liabilities than one of concentration in the home market

Enforcement of Anti-money laundering

1. US: A) FinCEN (within Treasury) implements AML policy, B) Requires financial institutions to: Prevent, Detect, Report 2. Global: A) Financial Action Task Force (FATF) est. 1989, B) 34 country and 2 regional group members (187 "partner countries" in network of regional bodies), C) Monitors members' implementation of agreed policies, D) Follows and analyzes trends in illicit money flows, E) Promotes global adoption (supported by member sanctions on non compliant countries)

Leverage

1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. 2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. 3. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10. 4. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders. 5. Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.

"Boys will be boys: Gender, Overconfidence, and common stock investment" by Brad Barber and Terence Odean

1. Theoretical models predict that overconfident investors trade excessively. 2. Paper tests this prediction by partitioning investors on gender. 3. Psychological research demonstrates that, in areas such as finance, men are more overconfident than women. Thus, theory predicts that men will trade more excessively than women. 4. Using account data for over 35,000 households from a large discount brokerage, we analyze the common stock investments of men and women from February 1991 through January 1997. We document that men trade 45 percent more than women. Trading reduces men's net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women.

"Yesterday's Heroes: Compensation and Creative Risk-Taking," by , Ing-Haw Cheng, Harrison Hong and Jose Scheinkman

1. There are substantial cross-firm differences in residual pay (defined as total executive compensation controlling for firm size) 2. Residual pay is correlated with price-based risk-taking measures including firm beta, return volatility, the sensitivity of firm stock price to the ABX subprime index, and tail cumulative return performance 3. These risk-taking measures are correlated with short-term pay such as bonuses and options even controlling for longer-term incentives such as insider ownership stakes 4. Finally, compensation and risk-taking are not related to governance variables; but they do covary with ownership by institutional investors who tend to have short-termist preferences and the power to influence firms' management policies 5. These findings suggest that residual pay measure is also potentially picking up firm-wide, high-powered incentives not captured by insider ownership 6. They also suggest that the correlation between residual pay and firm risk-taking is due to investors with heterogeneous short-termist preferences investing in different firms and incentivizing them to take different levels of risks

"Trends in Financial Innovation and Their Welfare Impact an Overview" by Franklin Allen

1. There is a fair amount of evidence that financial innovations are sometimes undertaken to create complexity and exploit the purchaser. Thus financial innovation does have a dark side. As far as the financial crisis that started in 2007 is concerned, securitization and subprime mortgages may have exacerbated the problem. However, financial crises have occurred in a very wide range of circumstances, where these and other innovations were not important. 2. There is evidence that in the long run financial liberalization has been more of a problem than financial innovation. There are also many financial innovations that have had a significant positive effect. These include venture capital and leveraged buyout funds to finance businesses. In addition, financial innovation has allowed many improvements in the environment and in global health. 3. On balance it seems likely its effects have been positive rather than negative.

What is liquidity?

1. There is an intuitive notion of liquidity—the capacity to meet one's current obligations or desires 2. Some use the term "money" or "moniness" to mean essentially the same thing (Gorton et al), but money has a specific meaning and measures in macroeconomics 3. Range of definitions in practice: market liquidity, portfolio liquidity, systemic liquidity 4.There are no widely used general measures of liquidity 5. It is nevertheless a critical dimension of finance and at the heart of financial crises and of much government intervention in markets 6. Think of liquidity as the capacity to make payments in the short runliquidity and solvency of an institution

Bagehot's Principles

1. These principals have withstood the test of time even if implementation cannot always be absolutely strict 2. The lender of last resort has been applied to countries as well as financial systems (IMF as a LoLR)

Did anyone who worked on these Basel agreements study mean variance portfolio analysis? Is this good or bad?

1. They did not 2. It's bad - systemic risk not separated from specific risk 3. Given that complexity is bad, not so much of a worry 4. Big problems arise, when values of big values of assets all declining together, because of liquidity issues.: Mean variance doesn't matter so much then.

Cognitive bias

1. Think of a cognitive bias as a rule of thumb that may or may not be factual. 2. Home bias: the tendency for investors to invest in a large amount of domestic equities, despite the purported benefits of diversifying into foreign equities. This bias is believed to have arisen as a result of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs. 3. Investing in foreign equities tends to lower the amount of systematic risk in a portfolio because foreign investments are less likely to be affected by domestic market changes.However, investors from all over the world tend to be biased toward investing in domestic equities. For example, an academic study from the late 1980s showed that although Sweden possessed a capitalization that only represented about 1% of the world's market value of equities, Swedish investors put their money almost exclusively into domestic investments.

Regulatory Response to CDS

1. US and EU are in the process of pushing CDSs and other derivatives into clearing houses 2. US is in the process of moving trading of CDSs and other derivatives out of banks (Lincoln amendment to Dodd Frank)

Bernie Madoff's Ponzi Scheme: Why was there failure

1. Three possibilities: A) Madoff's social and professional stature led the SEC to not look closely, B) SEC lawyers did not have the financial sophistication to understand the evidence in front of them, C) Laissez faire philosophy of the SEC at the time resulted in a lack of care 2. Probably some of all three, but second seems to have been decisive 3. SEC Inspector General found regarding the action taken on the Markopolus evidence that "The relatively inexperienced Enforcement staff failed to appreciate the significance of the analysis in the complaint, and almost immediately expressed skepticism and disbelief. Most of their investigation was directed at determining whether Madoff should register as an investment adviser or whether Madoff's hedge fund investors' disclosures were adequate." 4. The SEC IG found no evidence of irregular influence even though an SEC Assistant Director had "a romantic relationship with Bernard Madoff's niece."

Why Classical LOLR Lends at Penalty Rate

1. To discourage overuse and incentivize prompt repayment 2. Penalty may be hassle rather than or in addition to a rate premium

Special Purpose Vehicle

1. To initiate a securitization, a company must first create what is called a special purpose vehicle (SPV) in the parlance of securitization. 2. The SPV is legally separate from the company, or the holder of the assets. 3. Typically a company sells its assets to the SPV. The payment streams generated by the assets can then be repackaged to back an issue of bonds. 4. Or, the SPV can transfer the assets to a trust, which becomes the nominal issuer. In both cases, the bonds are exchanged with an underwriter for cash. 5. The underwriter then sells the securities to investors. Unlike other bonds, securities backed by mortgages usually pay both interest and a portion of the investor's principal on a monthly basis.

Why have deposit insurance?

1. To protect unsophisticated depositors 2. To remove incentives for runs on banks 3. US and other deposit insurance programs have been developed for a mix of these objectives, but pressure to respond to runs has created implicit insurance and hence moral hazard

Section 13(3) of the Federal Reserve Act

1. To respond to the financial crisis, the Federal Reserve System looked beyond its traditional monetary policy tools to restore economic stability. 2. Between March and November 2008, the Board of Governors of the Federal Reserve System (Board), citing "unusual and exigent circumstances," exercised its authority under section 13(3) of the Federal Reserve Act (12 U.S.C. § 343) to authorize six lending facilities to support overall market liquidity. 3. The Federal Reserve Bank of New York (FRB-NY) was authorized to implement and operate the Term Securities Lending Facility (TSLF) including the TSLF Options Program (TOP), Primary Dealer Credit Facility (PDCF), Commercial Paper Funding Facility (CPFF), Money Market Investor Funding Facility (MMIFF), and Term Asset-Backed Securities Loan Facility (TALF). 4. The Federal Reserve Bank of Boston (FRB-Boston) was authorized to implement and operate the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF).

Outsiders

1. Traditional insiders include directors, controlling shareholders, agents and others in clearly fiduciary roles. 2. Other parties who by their relationship with the corporation or its affiliates, competitors etc. have gained access to inside information are termed "outsiders." 3. This category includes market professionals, independent contractors, business associates, and persons with a unique ability to affect the market in the corporation's shares.

Collaterized Mortgage Obligation

1. Turns pools of 30-year mortgages into collections of 2-, 5-, and 10-year bonds that could appeal to a wide range of investors. The homeowner in Albuquerque could now tap funds from New York, Chicago, or Tokyo, a change that Ranieri figures cuts mortgage rates by two percentage points. Soon everything from credit-card balances to auto loans was being repackaged. 2. Growth in the pass-through market inevitably led to innovations especially as originators sought a broader MBS investor base. In response, Fannie Mae issued the first collateralized mortgage obligations (CMO) in 1983. 3. A more complicated twist on passthroughs, CMOs redirect the cash flows of trusts to create securities with several different payment features. The central goal with CMOs was to address prepayment risk—the main obstacle to expanding demand for pass-throughs. 4. As part of the Tax Reform Act of 1986, Congress created the Real Estate Mortgage Investment Conduit (REMIC) to facilitate the issuance of CMOs. 5. Today almost all CMOs are issued in the form of REMICs. In addition to varying maturities, REMICs can be issued with different risk characteristics. REMIC investors—in exchange for a higher coupon payment—can choose to take on greater credit risk. Along with a simplified tax treatment, these changes made the REMIC structure an indispensable feature of the MBS market. Fannie Mae and Freddie Mac are the largest issuers of this security.

"When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009" by Marcin Kacperczyk and Philipp Schnabl

1. Twice during the financial crisis of 2007-2009, the commercial paper market nearly dried up and ceased being perceived as a safe haven 2. Major interventions by the Federal Reserve, including large outright purchases of commercial paper, were eventually used to support both issuers of and investors in commercial paper 4. Scale of the Federal Reserve's response was unprecedented—including a blanket guarantee of money market investment worth $3 trillion and direct purchases of commercial paper of up to $370 billion

The Office of Foreign Assets Control

1. U.S. financial sanctions are imposed by U.S. statutes and Executive Orders, and generally implemented through regulations. The Office of Foreign Assets Control (OFAC) within the U.S. Department of the Treasury (Treasury), in consultation with the U.S. Department of State and sometimes other federal agencies, generally has primary responsibility for implementing these financial sanctions 2. As a key part of its efforts, OFAC maintains the Specially Designated Nationals and Blocked Persons list (the SDN list). The SDN list contains individuals, companies, and other entities whose assets are blocked, generally because they are owned or controlled by, or acting for or on behalf of, sanctioned countries, or are designated under non-country-specific programs, such as those targeting terrorists and foreign narcotics traffickers. Collectively, these individuals, companies, and other entities are "Specially Designated Nationals" (SDNs). With certain exceptions, U.S. persons are generally prohibited from transacting with SDNs. In addition, U.S. persons are generally prohibited from engaging, without OFAC's authorization, in most transactions in or with certain countries or geographic areas targeted by economic sanctions

Underwriter in Mortgage Markets

1. Underwriters—usually investment banks— serve as intermediaries between the issuer (the SPV or the trust) and investors. 2. Typically, the underwriter will consult on how to structure the ABS and MBS based on the perception of investor demand. 3. The underwriter may, for example, advise the SPV to issue different tranches each with specific characteristics attractive to different segments of the market. 4. Underwriters also help determine whether to use their sales network to offer the securities to the public or to place them privately. 5. Perhaps most importantly, underwriters assume the risk associated with buying an issue of bonds in its entirety and reselling it to investors.

Effectiveness of sanctions

1. Unilateral purely financial sanctions are weak in producing behavioral change: A) Others will do the business--Cuba, B) Exception—Iranian asset freeze in 1979 provided a chip in negotiations for hostage release, C) Dollar finance infrastructure gives some leverage over foreign financial institutions 2. Multilateral sanctions can be costly to the target: A) Libya gave up its nuclear program, B) Have seen North Korea adjust behavior at times to lighten sanctions 3. Multilateralism also a check on policy driven by a narrow interest 4. Factors favoring effectiveness (Gary Hufbauer) Imbalance of power between imposer and target: A) Broad based (don't stop lending and permit a soccer game—State proposal for Iran in 1995), B) Quick and decisive, not gradual, C) Avoid high costs on imposer 5. Sanctions aimed at undermining a government can backfire when they hurt the general population more than the leadership (Cuba, Iran) 6. Gaining a stronger negotiating position by taking something to give up may be a more realizable objective than direct dissuasion. Key questions are those of the wisdom of any foreign policy: What are the Interests? Values? Leverage?

Three ways to meet an obligation or make a purchase

1. Use money balances (cash or a checking account) 2. Sell an asset for cash and use the proceeds (an asset that one can sell without foregoing much future value is liquid) 3. Borrow money (or use a credit card) and use the proceeds 4. We learned in the financial crisis that financial positions can involve obligations that impair liquidity in a crisis—collateral obligations

Bancassurance

1. Very much a European model—France a leader. Southern European followers: A) BNP Paribas—Cardif, B) Societe Generale 2. Developing in emerging markets 3. Was allowed for the US under Gramm Leach Bliley 4. But the only large US banking and insurance combine was dissolved—Citi—Travelers 5. Why the difference between Europe and the US? Tax advantages in Europe? 6. Developing rapidly in Latin America and Asia but with different styles

High profile enforcement of the Foreign Corrupt Practices Act

1. Wal-Mart is currently in a case involving payments to Mexican officials to get approval for new stores: A) Justice department has opened a criminal case, B) Walmart has spent $439 million to internally investigate 2. Las Vegas Sands currently under investigation for payments in Macau alongside money laundering charges (settled) and private litigation 3. Siemens paid $800 million in the US and €596 in Germany to settle cases of corruption globally over the period 1999-2007: A) Two CEOs forced out (the second survived as CEO of Alcoa), B) A recipient in China was sentenced to death in 2011 but with 2 year reprieve 4. Spotlight on finance--JP Morgan under investigation over hiring practices in China

The fundamental point: market failure and government failure

1. We have looked at how markets produce bad outcomes that can be attributed to: A) Principal agent problems, B) Asymmetric information, C) Asymmetric power in markets, D) Herd behavior, E) Other sub optimal behavior, F) Unanticipated results of innovation 2. But the record of government failure is at least as disturbing

Fannie Mae: Why was there failure

1. Weak oversight by HUD with an interest in expanded activities and little financial expertise 2. Not subject to regulation by financial agencies 3. Crony capitalism American style 4. Power of the home builder--home financer complex

Sources of failure relative to public interest ideal: Behavioral government/wrong incentives

1. What economists call non-rational behavior anyone else would call people being people 2. Difficult to distinguish behavioral effects from distorted incentives (they may often be mixed) 3. Two aspects of behavior especially impact on policy processes: A) Loyalty to the group (survival and power of the agency becomes the most important thing), as turf issues can dominate policy concerns, B) Focus on one narrow objective instead of the big picture (Availability bias? Reinforced by group dynamics—what will the agency be judged on?), which increases unintended consequences

Policy questions

1. What is the value of achieving the objective? 2. Will the policy be effective?: A) Amazing how little weight this gets in Washington, where the value is often in being seen to be doing something even if it is ineffective, B) In the international domain, whether a policy is implemented unilaterally or multilaterally is often critical for effectiveness 3. What are the costs to US interests?: A) Economic interests—unilateral or multilateral is often critical to this, B) Foreign policy interests, C) Impact on friends as well as adversaries, D) Demonstration of power or lack of it 4. What is the cost-benefit balance?

Efficient Markets Hypothesis (EMH)

1. When information arises about an individual stock or about the stock market as a whole, investors act on that information without delay, causing the price of each stock to adjust so that it reflects completely all that is known about its future prospects 2. Similarly, any information that is contained in the past history of stock prices will be fully reflected in current prices. In an efficient market, no arbitrage opportunities are possible 3. The efficient-market hypothesis does not assert that the current tableau of stock prices will prove to have been correct when viewed in hindsight. Stock markets can and do make mistakes. Even in efficient markets we must recognize that today's stock price can only be estimated by calculating the discounted present value of all cash flows expected in the future. Such flows can only be estimated with considerable imprecision.

Efficient market

1. When information arises about an individual stock or about the stock market as a whole, investors act on that information without delay, causing the price of each stock to adjust so that it reflects completely all that is known about its future prospects 2. Similarly, any information that is contained in the past history of stock prices will be fully reflected in current prices. In an efficient market, no arbitrage opportunities are possible 3. The efficient-market hypothesis does not assert that the current tableau of stock prices will prove to have been correct when viewed in hindsight. Stock markets can and do make mistakes. Even in efficient markets we must recognize that today's stock price can only be estimated by calculating the discounted present value of all cash flows expected in the future. Such flows can only be estimated with considerable imprecision.

"The role of securitization in mortgage lending" by Richard Rosen

1. When subprime mortgages started to experience problems, a variety of organizations that supported or owned CDOs and SIVs began to suffer losses. A number of hedge funds and banks (including many non-U.S. banks) reported losses related to investments in U.S. subprime mortgage loans or subprime-loan-based securities. As a result, news reports began to feature terms such as MBS, CDO, and SIV. 2. This article demystifies these terms by explaining what the abbreviations stand for and how these financial instruments work.

"Psychology and economics" by Rabin

1. While standard economics assumes that each person maximizes stable and coherent preferences given rationally-formed probabilistic beliefs, psychological research teaches us about ways to describe preferences more realistically, about biases in belief-formation, and about ways it is misleading to conceptualize people as attempting to maximize stable, coherent, and accurately perceived preferences 2. We can confront plausible hypotheses about human behavior with both healthy skepticism and genuine curiosity, empirically test their validity, and carefully draw out their economic implications. And, as we apply these rigorous standards, we can then begin to treat claims that (say) investors irrationally infer too much from short-term performance, or that employees feel resentful when mistreated, as presumptively plausible and presumptively relevant hypotheses worth keeping in mind in our economic analysis

Policy Response to Eurodollars

1. Worry about monetary control: A) Except for reserve requirements on flows into and out of US, not much was done, B) Over time, Federal Reserve became comfortable with its instruments 2. US sought to reduce competitive edge of London as a financial center: A) Established International Banking Facilities 1981 (removed reserve requirements on foreign deposits), B) Eventually removed reserve requirements on time deposits altogether 3. Develop infrastructure for collective oversight of international banking: A) Basel Committee established 1974, B) Basel Concordat on supervisory responsibility 1975, C) Worked with Fed in addressing issues in clearing and settlement, D) Basel Accord on Capital Standards established 1988, E) Has continued to respond to events 4. Manage the Latin American debt crisis to avoid banking collapse 5. Collective response to offshore financial centers with weak oversight: A) Financial action task force focus on money laundering, B) Supervisory coordination with Basel Committee 6. Develop central bank swaps to provide liquidity in the event of a dollar drain from non US banks—first implemented 2007

Time inconsistency

1. Yet a case for rules over discretion arises from the problem of time inconsistency of policy. In some situations policymakers may want to announce in advance the policy they will follow to influence the expectations of private decisionmakers. But later, after the private decisionmakers have acted on the basis of their expectations, these policymakers may be tempted to renege on their announcement. Understanding that policymakers may be inconsistent over time, private decisionmakers are led to distrust policy announcements. In this situation, to make their announcements credible, policymakers may want to make a commitment to a fixed policy rule. 2. Time inconsistency: A) Moral hazard from implicit support (to big to fail), B) Adverse selection (retirement saving decisions) 3. Moral hazard from implicit support (too big to fail): Regulators say they're not going to rescue too big to fail firms in times of crisis, but then they do, but the alternative is not pretty. Banks thus have an incentive to build up risk and not prepare for financial armageddon. 4. Adverse selection (retirement saving decisions): Including retirement choice creates an additional layer of time inconsistency that requires non-standard control techniques: not only do individuals procrastinate saving for retirement, but they also make and then break plans about their future retirement age. 5. Governments behave in time inconsistent ways every day and yet politicians and officials are amazed that they are not believed.

Four economic mechanisms through which the mortgage crisis amplified into a severe financial crisis

1. borrowers' balance sheet effects cause two "liquidity spirals." When asset prices drop, financial institutions' capital erodes and, at the same time, lending standards and margins tighten. Both effects cause fire-sales, pushing down prices and tightening funding even further 2. The lending channel can dry up when banks become concerned about their future access to capital markets and start hoarding funds (even if the creditworthiness of borrowers does not change). 3. Runs on financial institutions, like those that occurred at Bear Steams, Lehman Brothers, and Washington Mutual, can cause a sudden erosion of bank capital 4. Network effects can arise when financial institutions are lenders and borrowers at the same time. In particular, a gridlock can occur in which multiple trading parties fail to cancel out offsetting positions because of concerns about counterparty credit risk. To protect themselves against the risks that are not netted out, each party has to hold additional funds. ("Deciphering the Liquidity and Credit Crunch 2007-2008" by Markus Brunnermeier)

Measures of the correlation of risk of an institution with systemic risk

1. direct spillovers—interconnectedness 2. indirect spillovers—crowded trades 3. procyclicality 4. size 5. being in a herd

"The Power of Suggestion: Inertia in 401(K) Participation and Savings Behavior" by Brigitte Madrian and Dennis Shea

1.Before the plan change, employees were required to affirmatively elect participation in the 401(k) plan. After the plan change, employees were automatically and immediately enrolled in the 401(k) plan unless they made a negative election to opt out of the plan. Although none of the economic features of the plan changed, this switch to automatic enrollment dramatically changed the savings behavior of employees. 2. 2 key findings. 1) 401(k) participation is significantly higher under automatic enrollment. 2) the default contribution rate and investment allocation chosen by the company under automatic enrollment has a strong influence on the savings behavior of 401(k) participants. 3. A substantial fraction of 401(k) participants hired under automatic enrollment exhibit what we call "default" behavior--sticking to both the default contribution rate and the default fund allocation even though very few employees hired before automatic enrollment picked this particular outcome. This "default" behavior appears to result both from participant inertia and from many employees taking the default as investment advice on the part of the company. 4. Overall, these results are consistent with the notion that large changes in savings behavior can be motivated simply by the "power of suggestion." 5. To turn automatic enrollment from a win-lose proposition to a win-win proposition, employers must find ways to move employees into higher contribution rates and more aggressive investment strategies.

Housing Finance Timeline

1933: The Federal Deposit Insurance System and Home Owners Loan Corporation were established. 1936: The Federal Housing Administration was created. 1938: Fannie Mae was created to provide a secondary market by for FHA-insured loans. 1944: VA loan program was created as part of the Veterans Bill of Rights. 1948: Fannie Mae begins to purchase VA loans. 1968: HUD and Ginnie Mae were created, and Fannie Mae became a shareholder-owned government-sponsored enterprise. 1970: Freddie Mac was created (the Federal Home Loan Mortgage Corporation Act). 1981: Savings & loans were allowed to invest in ARMs, and deposit ceilings were removed. 1982: Savings & loans securitize and sell off below-market-rate mortgages. 1986: The Tax Reform Act of 1986 eliminated all interest-related personal deductions except for mortgages and home equity loans. 1989: Freddie Mac was restructured as a publicly traded corporation, and the Federal Institution Reform Recovery and Enforcement Act passed.

Floating rate note

A bond (note) that has a variable coupon or rate of interest

Foreign bond

A bond issued in the domestic currency of a foreign country by a foreign entity

Putable note

A bond that allows the holder to force the company to purchase the bond at par usually on certain fixed dates

Convertible bond

A bond that can be converted into shares or some other asset at some point

Eurobond

A bond that is sold by a domestic or foreign government, institution or company in currency that is different from the country where the bond is issued

"Federal Reserve Liquidity Provision During the Financial Crisis of 2007-2009" by Michael Fleming

A coherent report on what the Fed did and a non-technical review of academic research on its effects 1. The Federal Reserve initiated or expanded numerous liquidity facilities during the financial crisis of 2007‐2009 in accord with its lender‐of‐last‐resort role 2. The evidence supports the conjecture that the facilities were structured in line with time‐honored principles of central bank liquidity provision: short‐term lending against collateral at a penalty rate 3. The evidence uncovered to date also broadly supports the conclusion that the programs were effective at mitigating the strains in financial markets.

The innovation of Credit Default Swaps (CDS)

A contract in which 1. the seller will compensate the buyer in the event of a credit event by a reference obligor (default, restructuring, moratorium or other deviation from contractual payments) 2. The buyer makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives the compensation if there is a credit event 3. CDSs are usually documented according to a standard established by the International Swaps and Derivatives Association (ISDA) 4. A credit event is determined by ISDA 5. Compensation may be payment of the face value in return for the security or determined by an auction conducted by ISDA 6. Common for the parties to post collateral

"Basel Becomes Babel as Conflict Rules Undermining Safety" by Yelman Onaran

A recent journalist's overview with a cynical perspective

Should LoLR be called a bailout?

A true LoLR operation is not a bailout 1. Important to distinguish loans on behalf of the taxpayer from grants with their money 2. Social benefit to cost can be infinite 3. Nature of beneficiaries

Have covered a lot of ground (2)

Additional policy challenges 1. Innovation 2. Time inconsistency: Moral Hazard 3. Complexity 4. Non-financial policy objectives

Problems with Aligning Management's Interest with That of Shareholders

Aligning management interests with shareholders may lead to excessive risk taking 1. Optimal contracting issues apply to others besides shareholders e.g. debt holders (distortions grow with leverage), deposit insurers 2. Debt holders and insurers may charge for the increased risk they take but management may still have incentive to take on excess risk: A) The put option embedded in share ownership B) If debt holders can observe risk they will demand payment that aligns incentives C) But even rational expectations in the absence of actual observation leads to excessive risk taking 3. Owners may have an incentive to reduce this distortion since they pay for passing risk to rational debtors 4. Uninformed debtors and flat rate deposit insurance leads shareholders as well as incentive compensated management to take on more risk 5. But empirical work does not suggest excessive incentive intensity

New Approaches to Systemic Risk

All of these should be of concern to systemic risk authorities 1. Measures of systemic risk 2. Measures of the correlation of risk of an institution with systemic risk

"Money Laundering and Terrorism Financing: An Overview" by Jean-Francois Thony

An aging snapshot of an evolving policy area, but gives a picture of the policy environment

"Restoring International Financial and Monetary Stability" by Jeffrey Shafer

An immediate post crisis view of what needs attention to avoid a repeat 1. Need to build more effective financial supervision and regulation 2. Business practices require more regulation and oversight than they have recently received 3. Moral hazard not only justification of safety and soundness regulation: it deals with market failures taxpayers are going to foot the bill for 4. Need Market Stability Authority

Risk managers

An incentives challenge 1. At an individual level it is almost impossible to assign credit or blame to risk managers except for infrequent big events 2. Main issue may be to incentivize good people to sign up: A) Compensation has always lagged revenue generators B) But hard to give big rewards without visible big contributions

Liquidity in Unchanged Environment

An individual or institution can suffer a loss of liquidity in an unchanged environment 1. Adverse events may call its access to credit in question e.g. losing job, bad earning, for bank loss of confidence 2. Hence it is important to distinguish between hard liquidity that is certain (liquid assets and firm credit lines) and more contingent liquidity (borrowing power) that can disappear

Determinants of Liquidity

An individual's or institution's liquidity depends on its cash flow as well as its capacity to raise funds to meet it

Moral Hazard

An insurance industry term 1. Someone who buys insurance has a reduced incentive to make the optimal effort to avoid a loss 2. This is why insurance companies reduce premiums if you put in a fire alarm and do other risk reducing things 3. It is why the insurance industry created UL (Underwriters Laboratory) to strengthen the market for electrical appliances with lower fire risk

"Market Distress and Vanishing Liquidity: Anatomy and Policy Options" by Claudio Borio

Another look at how things go wrong but a bit vague on prevention measures. Perhaps most useful as a view on issues discussed 1. Despite appearances, the genesis and dynamics of market distress resemble quite closely those of banking distress and that, contrary to conventional wisdom, the growth of markets for tradable instruments, and hence the greater scope to sell assets and raise cash, need not have reduced the likelihood of funding (liquidity) crises 2. At times of distress,in contrast to more normal times, risk management practices, funding constraints and counterparty risk become critical determinants of market liquidity 3. Articulating an appropriate policy response calls for an approach that takes full account of the interdependencies between the behavior of market participants and market dynamics

"Basel III: An Overview" by Peter King and Heath Tarbert

Another report on what the Basel Committee has done. Does not tie into Dodd Frank. 1. Basel I (1988)'s achievement of uniform risk-weight categories ironically emerged as one of the framework's greatest flaws, as the categorical risk weights were so crudely calibrated they encouraged regulatory arbitrage 2. Basel II (2004) failed, because it relied on credit agency rating, banks' own risk management models, ignored off-balance sheet risks and let bank capital levels erode 3. Basel III seeks to increase quality and quantity of capital

Application of LOLR vs. Theory

Application can be harder than theory 1. What collateral quality and haircuts should be accepted (how good is good?)? 2. Can the market channel additional liquidity or is targeting required? 3. Is concern about a negative message from providing support serious, and if so how to mitigate? 4. How much risk of insolvency or loss of value of paper to accept in the face of uncertainty? 5. LoLR's place in the creditor queue—preferred creditor status makes sense when a LoLR goes in when no one else would (IMF as a sovereign LoLR) 6. What to do when solvency is doubtful but risk of contagion is great? (Lehman)

Should finance have special compensation provisions?

Arguments for: 1. High leverage increases the incentivization of risk taking in equity compensation 2. Moral hazard 3. Systemic spillovers 4. Corporate governance failures may have higher cost in financial sector Arguments against: 1. Shareholders should be incentivized to find the best possible pay structure 2. Will be gamed with introduction of new distortions (intensity of incentive compensation was increased by 1993 tax change) Arguments for suggest that if government intervenes, it should be on the structure not the size TARP provisions were in the role of controlling stakeholder as well as public authority

"Sanctions" by Kimberly Elliott, Gary Hufbauer and Barbara Oegg

Assessment of nearly two hundred observations of economic sanctions imposed since World War I indicates that economic sanctions tend to be most effective at modifying the target country's behavior under the following conditions 1. The goal is relatively modest: winning the release of a political prisoner versus overthrowing the regime of Saddam Hussein, for example. Less ambitious goals may be achieved with m ore modest sanctions; this also lessens the importance of multilateral cooperation, which is often difficult to obtain. Finally, if the stakes are small, there is less chance that a rival power will step in with offsetting assistance. 2. The target is much smaller than the country imposing sanctions, economically weak, and politically unstable. The average sender's economy in the 198 episodes studied was 245 times as large as the economy of the average target. (Moreover, this calculation excludes 21 instances in which a major power targeted a microstate, and the GDP ratio exceeded 2000.) 3. The sanctions are imposed quickly and decisively to maximize impact. The average cost to the target as a percentage of GNP in successful cases was 2.6 percent and in failures was only 1.5 percent (excluding Iraq), while successful sanctions lasted an average of only three years, versus eight years for failures. 4. The sender avoids high economic or political costs to itself.

What gave rise to Basel II?

Banks didn't like Basel 1 formulas

Dependence on Liquidity

Besides creating liquidity, financial Institutions are also dependent on it 1. An institution that stands ready to supply funds to another to make payments must have access to them themselves through a) deposits with other institutions (including the Fed—the ultimate source of liquidity), b) credit lines, c) repos, d) issuance of market debt and e) sale of assets in a liquid market 2. Regulators set liquidity requirements for financial institutions

Measurement and Policy

Better measurement would lay the basis for better policy 1. Borrower leverage policies: a) Loan to value ratios for classes of loans and b) leverage for derivatives (high initial requirements to reduce collateral calls) 2. Realigned capital ratios to reflect systemic risk 3. Regulations and elements of a supervisory discussion could be designed to meet objectives with respect to the systemic risk contribution of the institution

Traders compensation

Blinder faults trader compensation as a contributor to the crisis. The put option element in traders comp may be very large and 1. Incentivizes risk taking 2. Selects for risk lovers 3. Incentivizes carry trades (small probability of big losses for a relatively predictable gain) 4. Returns are not well risk (capital cost) adjusted 5. Compensation for profit on open positions incentivizes shading of marks (JP Morgan Whale Trade) But are not shareholder and management interests aligned with the public interest? Externalities as well as imperfect solutions? Will regulation lead to a better outcome than companies will find after the crisis?

Mortgage-backed securities (MBS)

Bond-like debt instrument backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holder of the security

"Rethinking Principles of Bank Regulation, a review of Admati and Hellwig's Bankers New Clothes" by Roger Myerson

Both the book and the review attach too much importance to capital and not enough to liquidity in my view. 1. Financial regulatory reforms can be reliably effective only when their basic principles are understood by informed citizens, and that Admati and Hellwig's book is a major contribution toward this goal, as it clearly lays out the essential case for requiring banks to have more equity 2. A bank may incur some real cost from equity financing, but it is primarily due to the fact that an increase of equity will transfer to the bank's owners a larger share of the bank's risks, which otherwise with debt financing might be passed on to creditors or taxpayers 3. It might be better to define equity requirements instead as a fraction of debt liabilities, to put the focus on the part of the balance sheet that actually makes equity necessary

Deflation of Bubbles and Liquidity Collapse

Bubbles can deflate without a liquidity collapse 1. The internet bubble did not produce large multiplier effects 2. It can soften the blow if monetary policy eases 3. The loss of illusory wealth must still be absorbed and this will impact the economy, but the effects are not multiplied in the financial sector 4. The losses from declining real estate prices were multiplied many times in the subprime crisis as market generated liquidity dried up

Cost of Dodd-Frank's Restriction of LOLR Powers

Could have economic costs in two ways: 1. Regulation and risk management could limit credit and hold back economic growth in absence of a strong LoLR 2. We could find ourselves without the capacity to respond effectively in the event of a future crisis But Lender of last resort operations have often entered new legal territory with the understanding that it could only be done once

Do the new US capital requirements go too far or not far enough in raising capital ratios of banks?

Countercyclical buffers have to be mechanically determined, not determined by politicians or regulators or central bankers.

Why was Basel III created?

Credit ratings and bank risk-weighting failed 1. In Basel III, banks can use credit ratings. Europeans passed CRE III, which, like Dodd-Frank, gets rid of credit agency ratings 2. Basel III moves to tiers instead of buckets. 3. Brunnermeier piece very good on what we need to do in terms of regulations: argues that risk-weightings can make system more risky and that leverage ratio is a good check. Probably want to have both.

Deposit Insurance and Unsophisticated Depositors

Deposit insurance is supposed to protect unsophisticated depositors 1. It, however, would not give rise to greater moral hazard 2. But even in the absence of insurance there could be moral hazard on the part of bank owners who can take advantage of depositors

Deposit Insurance and Incentives for Runs on Banks

Deposit insurance is supposed to remove incentives for runs on banks 1. Ineffective unless insurance extends to all relatively short term deposits 2. Hence de facto insurance tends to cover much more than small deposits 3. In practice the FDIC (and TARP in 2008-09) has often protected most or all creditors of a bank (but when WAMU failed subordinated and senior unsecured debt was not paid in full) 4. Carries moral hazard for both management and potential depositors and other creditors

How Dodd-Frank Changed US Financial Regulatory System

Dodd Frank changed system only marginally 1. Got rid of 1 of 5 Federal depository institution regulators 2. Rationalized some responsibilities 3. Established the Financial Stability Oversight Council (FSOC) 4. Established a Consumer Financial Protection Bureau (CFPB) within the Federal Reserve but functionally independent 5. Established a Federal Insurance Office in the Treasury but with no powers

Benefits of size (1)

Economies of scale 1. Economic research used to show these peaked at a relatively low level (about $50 billion) 2. More recent work shows scale extending further (an interesting paper suggest there are economies of scale for very large financial institutions but these accrue mainly to bankers, not to shareholders or customers 3. Peak may also reflect technical efficiency continuing to increase with scale while marginal managerial efficiency declines 4. Do the earlier research results reflect: A) Slow learning about how to achieve benefits of scale following relaxation of interstate limits by states in 1970s and 80s and Federally in 1994?, B) Increasing scale benefits over time from IT? 5. A clear Pareto optimality cost from policy of limiting scale below optimum, whoever gains from it

What do you think about allegations that the Fed was gave too easy terms to AIG's creditors when it took on its obligations?

Fed wanted everyone to know that their exposures were safe. If Fed had done so, markets would have questioned health of all institutions.

Creators of Liquidity

Financial institutions 1. They provide things a) deposits and credit cards usable to make payments, b) other short term and/or marketable assets (commercial paper) and c) standby credit lines 2. They are market makers 3. They supply funds to each other by engaging in repurchase agreements (repos)

Bernie Madoff's Ponzi Scheme: Lessons learned

For Regulation 1. You have to have people with power who understand finance in order to regulate it. 2. Outsiders may see a problem more clearly, especially if there appears to be a profitable activity to copy For investors 1. If it looks to good to be true it probably is 2. Trust but verify

Have covered a lot of ground (3)

Idealized government--Public interest theory 1. Social welfare maximization 2. Efficiency and distribution 3. Fairness Imperfect government 1. Rent seeking 2. Capture 3. Neglect of unintended consequences 4. Lacking in capacity 5. For sale to individuals or groups

Distress and Individual Liquidity

In distressed conditions the liquidity of assets or contingent sources changes

The drivers of innovation

Incentives: to create, increase or defend profits 1. Boost revenue 2. Cut costs Change 1. External Change 2. Fruits of R&D (Tax advantaged hybrid securities) 3. Creative idea (credit default swap)

Adverse selection (Defined)

Information Asymmetry can lead to two main problems, one of which is adverse selection, immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not be in optimal health may be more inclined to purchase life insurance than someone who feels fine.

Insider trading

Insider trading is the term used to describe "the act of purchasing or selling securities while in possession of material, nonpublic information about an issuer or the trading market for an issuer's securities"

Deposit insurance and financial institutions

Institutions covered by deposit insurance enjoy a lower cost of funds because depositors or buyers of their debt have no risk of loss 1. There is no market discipline on risk management except in the equity market 2. Without equity capital requirements banks can escape equity market discipline—no one has money at risk (except the insurance fund)

Liquidity-fed bubbles and their collapses

Liquidity fed bubbles followed by liquidity collapses are particularly devastating. Note The Minsky stages 1) Displacement- investor excitement generated by an innovation or policy change 2) Boom—credit standards are eased and borrowers count on rolling over debt, not repaying it on maturity 3) Euphoria—Asset price increases lead to credit extended on the expectation that debt service will be met by flipping of assets (Ponzi finance) 4) Profit Taking--smart money begins to exit 5) Panic—people realize that the world is not as they had thought. There is a rush to cash out and protect liquidity that the system cannot accommodate. Value is depressed by a multiple of the loss in fundamental value of real capita

The Price of Liquidity

Liquidity has a price 1. The interest foregone to hold more liquid assets or fees paid for a credit line is the price of liquidity 2. There is a demand for liquidity as portfolio managers from individuals to bank CFOs trade off paying to be liquid against the risk of being caught in an illiquid position. Examples of this: A) Higher interest rates induce people to become less liquid B) Growing confidence that market liquidity is robust and stable leads people to rely more on the market and less on cash for liquidity C) An increase in uncertainty raises the demand for liquidity and hence its price (interest rates)

Derivatives and Liquidity

Liquidity has become even more complicated with the explosion of derivatives 1. Who will owe money and who will receive money at the maturity of a derivative changes with every market price change 2. This gives rise to variable counterparty risk 3. Requiring collateral is the best way to avoid counterparty risk 4. This creates the risk of not having sufficient acceptable collateral when prices move adversely 5. Margin calls in 1929 had the same effect as collateral calls in 2008

How to think of LOLR

LoLR can be thought of as monetary policy in disturbed times 1. Some argue that LoLR can be fully implemented through open market operations to maintain an unchanged money supply (either high powered money or money held by the public) 2. This view misses some important thing

"Anatomy of a Financial Crisis" by Frederic Mishkin

Makes the case for asymmetrical information playing a key role in financial crises 1. Provides an asymmetric information framework for understanding the nature of financial crises 2. Provides the following precise definition of a financial crisis: A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities 3. As a result, a financial crisis can drive the economy away from an equilibrium with high output in which financial markets perform well to one in which output declines sharply. 4. Indicates that financial crises have effects over and above those resulting from bank panics and therefore provides a rationale for an expanded lender-of-last resort role for the central bank in which the central bank uses the discount window to provide liquidity to sectors outside of the banking system.

"What's Missing from Macroeconomics: Endogenous Leverage and Default" by John Geanakoplos

Makes the case for looking at leverage as well as at capital 1. Argues for the necessity of collateral and leverage in macro models 2. Leverage is absent from those models, even if lip service is paid to it now 3. Only by taking collateral seriously can one properly assess the effect on asset prices of new derivatives like credit default swaps 4. By writing down principal on loans so that the borrowers are above water, lenders and borrowers can both gain

Drivers of junk bond innovation

Market conditions 1. High and volatile interest rates made long-term fixed rate financing attractive for firms that had borrowed from banks at floating rates 2. High nominal interest rates increased the value of tax deductibility of interest payments—debt that had equity properties was tax advantaged over equity 3. Industrial restructuring by emerging private equity firms created demand from new and less highly rated businesses 4. Competitive tightening of returns in investment grade issuance and equity trading drove a search for new more profitable investment banking activities Regulatory and other government policy conditions 1. No restrictions on who could issue registered bonds as long as disclosure requirements were met 2. High interest rates result of Volcker Fed policy 3. Tax deductibility of interest payments but not dividends

Drivers of Eurdollar Innovation

Market conditions 1. Political risk faced by some investors in the US 2. Dollar flow to foreigners trading with US and demand to hold onto them 3. Demand for credit in dollars by foreigners 4. Both got a big boost after first oil shock in 1974 when OPEC dollar accumulation swelled Regulatory conditions 1. UK capital controls prevented international banking in London in sterling 2. From early 60s to 1974 capital controls in the US held interest rates in the US below market clearing rates much of the time 3. Interest rate ceilings (Fed Reg Q) also kept interest rates below market clearing at times—ended for large denomination CDs in 1973 4. US reserve requirements on demand and time deposits (Fed Reg D) was a cost factor in US banking not present abroad—the cost rose with interest rates in the 1970s; phased out by 1990 5. Special reserve requirements on eurodollar borrowing by US banks were used to manage US flows into and out of the eurodollar market from time to time in the 1960s and early1970s

Panic and LOLR

May follow if LoLR support is not timely and effectively targeted

Monetary Conditions During Crisis

Money demand exploded and was accommodated after Lehman bankruptcy The spikes of the spread of LIBOR (interbank lending rate)over Treasury rate in crisis indicated reluctance of banks to lend to one another and need for targeting

Regulatory Reform and Individual Institutions

Much regulatory reform has been to make the system safer by making individual institutions safer 1. Basel III and Dodd Frank capital requirements 2. Focus on Systemically Important Financial Institutions (SIFIs) 3. These measures arguably do more harm than good 4. Good work is being done on looking at the system as more than the sum of its pieces 5. Reading by Brunnermaier et al is one example that focuses on the countercyclicality problem 6. Work on tying capital requirements to correlation with systemic behavior (penalize high beta)

Innovation may require policy support to create needed infrastructure

Non-finance 1. Highways, traffic laws and police enforcement following the invention of the automobile 2. Regulation and allocation of spectrum though innovation in radio, television, cell phones Wi-Fi... Finance 1. Clearing and settlement systems 2. Rules and infrastructure for derivatives markets-initially undertaken by industry group (ISDA)

The objectives approach of the US Treasury 2008

Organizing thinking around objectives keeps them in the center of policy debate 1. Systemic Stability 2. Safety and soundness of insured firms 3. Business conduct 4. The Treasury also identifies a need for separate insurers and for a corporate finance authority to deal with disclosure and governance issues across all sectors

Have covered a lot of ground (4)

Policy issues that arise in finance 1. Supervision of individual institutions 2. Systemic supervision 3. Lender of last resort 4. Limits on activities 5. Disclosure and inside information 6. Consumer protection 7. Influencing consumer choices 8. Size and scope of institutions 9. Intervention to achieve other goals (special attention to housing)

More generally, what will be the effect of the new Basel rules on innovation? Can you see a good regulatory arbitrage opportunity?

Possibility for risk to build up in countries where regulators are lax and who attract business from abroad.

An uneasy relationship

Problems created for incumbents and for policymakers can create a policy bias against innovation. This is costly for economic growth and development. When innovation occurs, failure to respond can be costly too.

"Deciphering the Liquidity and Credit Crunch 2007-2008" by Markus Brunnermeier

Provides a clear presentation of liquidity in the context of the sub-prime crisis. Will come back to this in coming weeks. Prof. B. is arguably the best current financial macro scholar. Worth very close attention. 1. Financial innovation that had supposedly made the banking system more stable by transferring risk to those most able to bear it led to an unprecedented credit expansion that helped feed the boom in housing prices. 2. The second part of the paper provides an event logbook on the financial market turmoil in 2007-08, ending with the start of the coordinated international bailout in October 2008. 3. The third part explores four economic mechanisms through which the mortgage crisis amplified into a severe financial crisis.

Government objectives in finance

Public interest view 1. Efficient outcomes in regulated markets or through direct intervention 2. Compensate for power disparities 3. Meet government needs (facilitate financing of the government) Even an effective public interest government is often not going to be able to achieve the optimality of free choice in efficient markets. Governments cannot efficiently deal with needs that are different--all in the same objective position get the same

"Is the Discount Window Necessary? A Penn Central Perspective" by Charles Calomiris

Puts the issue of a LOLR in the context of a clear success story 1. Argues that the primary role of the discount window should be to provide occasional, temporary support to particular financial markets during localized financial crises 2. The benefits of the discount window revolve around information externalities across firms resulting from confusion over the incidence of bad news, or reductions in the net worth of market intermediaries 3. The Penn Central commercial paper crisis of 1970 crisis is visible in a pronounced decline in outstanding commercial paper, an increase in the interest rate spreads for commercial paper and for long-term debt, and declines in stock prices 4. Cross-sectional variation in abnormal stock returns indicates that, controlling for other factors, firms that were likely to have had outstanding debt in the form of commercial paper suffered larger negative returns during the onset of the crisis, and larger positive returns after the Fed intervened to lower the cost of commercial paper rollover 5. Paper clearly relevant in light of large run on CP in 2008

"Bubbles in Asset Prices" by Burton Malkiel

Reflections on the housing bubble and other bubbles by someone with a lifelong belief in close to efficient markets 1. Asset-price bubbles based on somewhat rational belief about asset and hard to deflate because of cost, risk and high rewards associated with exiting at the right time: virtually impossible to spot ex ante 2. Bubbles extremely difficult to spot, the bursting of bubbles has invariably been followed by severe disruptions in real economic activity 3. Because bubbles so hard to spot, policymakers should not use crude tool of monetary policy to pop them

Requirement for Large Lending of LOLR

Requires a strong official lender—central bank or government

Debt Exposure and Executives' Risk-Taking

Research suggest that increasing executives' debt exposure reduces risk taking 1. Deferred compensation and pension rights are a debt of the bank 2. Where these are a bigger part of compensation the effect is to reduce CDS spreads: proposal to link compensation to CDS spreads 3. FDIC researchers find more compensation in "inside debt" is correlated with better supervisory grades and higher capital

Management's Interests and Shareholders' Interests (Fahlenbrach, Stulz)

Research suggests management's interests are reasonably well aligned with shareholders. Financial institution with senior managers that had larger stakes did worse in the crisis 1. Consistent with shareholders wanting risk 2. Lack of selling before crisis consistent with not seeing the problems coming 3. Senior manages lost heavily

"Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis" by Hyun Song Shin

Review of an interesting British bank failure seen through the perspective of liquidity theory 1. Northern Rock's problems stemmed from its high leverage coupled with reliance on institutional investors for short-term funding 2. When the de-leveraging in the credit markets began in August 2007, Northern Rock was uniquely vulnerable to the shrinking of lender balance sheets arising from the tick-up in measured risks 3. Financial regulation that relies on risk-weighted capital requirements is powerless against such runs 4. Liquidity: when liquidity buffers are distributed throughout the financial system, the set of multiple buffers will act to reduce spillover 5. Raw leverage ratio: conditions. By preventing the build-up of leverage during good times, the leverage constraint dampens the effects of contracting leverage in bad times

"Five Years Later: Lessons from the Financial Crisis" by Jeffrey Shafer

Shafer's own Assessment of the crisis, a less technical version of Brunnermeier. Written after teaching this course last year 1. The deepest economic collapse in 75 years occurred because of a widespread failure across the financial system rather than a single cause 2. In order to safeguard the economy in the future, strong regulation, implementation and enforcement of systemic protections and emergency lending capabilities are needed 3. The causes of the crisis: global imbalances, a housing bubble, loose monetary policy, a very large increase in short-term market financing of broker dealers and portfolios, excessive leverage, and shadow banking 4. Institutions' vulnerability to loss of liquidity was at the core of the problems that arose:as institutions sought liquidity from the same markets, they destroyed value and exacerbated the systemic crisis

"Herd behavior and investment" by Scharfstein and Stein

Shows how herd behavior could be rational using a lot of math. A good example of the counterattack of the neoclassical economists. 1. This paper examines some of the forces that can lead to herd behavior in investment. Under certain circumstances, managers simply mimic the investment decisions of other managers, ignoring substantive private information. Although this behavior is inefficient from a social standpoint, it can be rational from the perspective of managers who are concerned about their reputations in the labor market. 2. Herd behavior can arise in a variety of contexts, as a consequence of rational attempts by managers to enhance their reputations as decision makers. In addition to reputational concerns, there are other factors that influence herding. One of these is the extent to which there are commonly unpredictable components to investment outcomes: correlated prediction errors lead to the "sharing-the-blame"effect that drives managers to herd. Also important is the nature of the managerial labor market: herding is more likely to be a problem when managers' outside opportunities are relatively unattractive, and when compensation depends on absolute rather than relative ability assessment

Stress Tests in the Wake of 2008

Stress tests have also gained importance in the wake of the crisis 1. Focuses on survivability in very bad conditions 2. Improves on conventional capital ratios by taking into account correlations between assets 3. Improves on conventional portfolio analysis by focusing on outlier scenarios instead of the risk of everyday events that are the focus of VAR (value at risk) and incorporates liquidity risk 4. But stress scenarios are unlikely to closely correspond to the next period of distress 5. Stress tests now play a key role in financial supervision, as Secretary Geithner used stress tests effectively to restore confidence in the spring of 2009

Ultimate Supplier of Liquidity

The Fed

"Causes of the Recent Financial and Economic Crisis" by Ben Bernanke

The Fed Chairman's views of events 1. Crisis triggers: 1) the prospect of significant losses on residential mortgage loans to subprime borrowers that became apparent shortly after house prices began to decline and 2) "sudden stop" in June 2007 in syndicated lending to large, relatively risky corporate borrowers 2. Causes of crisis: 1) dependence on Unstable Short-Term Funding, 2) Deficiencies in Risk Management, 3) Leverage, 4) Derivatives, 5) Statutory Gaps and Conflicts in regulation, 6) Ineffective Use of Existing Authorities, 7) Inadequate Crisis-Management Capabilities, 8) TBTF institutions 2. Loose monetary policy did not lead to crisis 3. The run-up in house prices primarily represented a feedback loop between optimism regarding house prices and developments in the mortgage market 4. This coupled with high rates of international investment created crisis

US Financial Regulatory System before Dodd-Frank

The US system was a mess before Dodd Frank 1. 5 Federal depository institution regulators 2. 50 state depository institution regulators 3. 1 Federal regulator of securities issuance, secondary markets, credit rating agencies and some futures and options 4. Another Federal regulator of commodities markets and other futures and options 5. 50 state securities regulators 6. 50 state insurance regulators (no Federal insurance oversight) 7. Dispersed consumer protection authority (but concentrated in the Federal Reserve Board) 8. A federal Housing Finance Agency 9. At least 3 insurance agencies with resolution powers 10. No formal coordination or dispute resolution process across agencies

"Big names drawn into Galleon web" by Kara Scannell

The conviction of Raj Rajaratnam on insider trading charges could force changes in business practices across corporate America and Wall Street, as senior executives respond to the breakdowns in compliance revealed in the trial, experts say. The trial exposed cracks in governance controls within some of the biggest names in the corporate world - ranging from Goldman Sachs to McKinsey, Moody's and IBM. Testimony revealed that traders and others were able to exploit friendships to reach into executive suites and boardrooms to gain access to secret information.

"Testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs" by Jamie Dimon

The public view of the CEO: said the following went wrong 1. Chief Investment Office (CIO)'s strategy for reducing the synthetic credit portfolio was poorly conceived and vetted 2. CIO's traders did not have the requisite understanding of the risks they took 3. The risk limits for the synthetic credit portfolio should have been specific to the portfolio and much more granular 4. Personnel in key control roles in CIO were in transition and risk control functions were generally ineffective in challenging the judgment of CIO's trading personnel 5. CIO, particularly the synthetic credit portfolio, should have gotten more scrutiny from both senior management and the firmwide risk control function

The future of the risk of systemic liquidity crunches

The risk of systemic liquidity crunches is unlikely to be eliminated 1. Hence an effective lender of last resort is indispensable 2. Attentiveness to capital does reduce the taxpayer risk of acting as lender of last resort

Test of Success for LOLR

The test of success is stability in the path of output and inflation, which stable monetary conditions should produce

"The Insider Trading Debate" by Jie Hu and Thomas Noe

There is a common core of opinion regarding the effects of insider trading on certain economic variables under some circumstances. In fact, this common core of opinion can be summarized fairly simply in three points: 1. Whenever other informationally advantaged investors are absent or insignificant, insider trading increases trading losses to investors and liquidity traders and makes markets less liquid. Otherwise, insider trading, by increasing competition between informed investors, may assist investors and liquidity traders. 2. Unless other informed agents are crowded out of the financial market, insider trading renders prices more informative, potentially increasing the efficiency of investment and capital budgeting decisions. 3. Insider trading opportunities provide low-cost, high-powered incentives for managerial performance. However, the incentives provided are imperfect for two reasons: insider trading encourages managers to undertake risky activities and investors to underprovide more traditional forms of compensation that may lead to increased managerial performance and reduced risk taking.

Powers of the state

To proscribe or prescribe 1. Price regulation (Regulation Q interest rate ceilings) 2. Quantities (proposed size limitations on bank assets) 3. Participation (licensing of new banks) 4. Process (disclosure requirements for a new issue) To subsidize or tax 1. Firms (Implicit guarantee of Fannie and Freddie) 2. Activities (under--priced deposit insurance Economists tend to favor taxes and subsidies over fixing prices or quantities—allows choice. But taxes are politically difficult to levy and the possibility of subsidies drives rent seeking. The cost of intervening if it must be done with quantity restrictions is almost always greater

Risk-weighted assets

To risk-weight the assets of a given bank, one must place them in different categories depending on their risk of default and then assign a weight to each of these categories

Runs and LOLR

Traditionally bank runs, but since Penn Central the potential for runs out of short term market instruments has been recognized

Finance is a popular sector for sanctions

US has industry dominance given use of the dollar and doesn't visibly cost jobs like halting an export Financial sanctions 1. Restrict lending or other investment 2. Restrict acceptance of deposits or investment 3. Block money transfers 4. Freeze accounts

"Understanding the Securitization of Subprime Mortgage Credit" by Adam Ashcraft and Til Schuermann

Until very recently, the origination of mortgages and issuance of mortgage-backed securities (MBS) was dominated by loans to prime borrowers conforming to underwriting standards set by the Government Sponsored Agencies (GSEs). The securitization process is subject to seven key frictions 1. Frictions between the mortgagor and the originator: predatory lending: Subprime borrowers can be financially unsophisticated 2. Frictions between the originator and the arranger: The originator has an information advantage over the arranger with regard to the quality of the borrower 3.Frictions between the arranger and third-parties: The arranger has more information about the quality of the mortgage loans which creates an adverse selection problem: the arranger can securitize bad loans (the lemons) and keep the good ones. This third friction in the securitization of subprime loans affects the relationship that the arranger has with the warehouse lender, the credit rating agency (CRA), and the asset manager. [adverse selection] 4.Frictions between the servicer and the mortgagor: In order to maintain the value of the underlying asset (the house), the mortgagor (borrower) has to pay insurance and taxes on and generally maintain the property. In the approach to and during delinquency, the mortgagor has little incentive to do all that. [Moral hazard] 5. Frictions between the servicer and third-parties: The income of the servicer is increasing in the amount of time that the loan is serviced. Thus the servicer would prefer to keep the loan on its books for as long as possible and therefore has a strong preference to modify the terms of a delinquent loan and to delay foreclosure. In the event of delinquency, the servicer has a natural incentive to inflate expenses for which it is reimbursed by the investors, especially in good times when recovery rates on foreclosed property are high. [Moral hazard] 6.Frictions between the asset manager and investor: The investor provides the funding for the MBS purchase but is typically not financially sophisticated enough to formulate an investment strategy, conduct due diligence on potential investments, and find the best price for trades. This service is provided by an asset manager (agent) who may not invest sufficient effort on behalf of the investor (principal).[Principal-agent] 7. Frictions between the investor and the credit rating agencies: The rating agencies are paid by the arranger and not investors for their opinion, which creates a potential conflict of interest. The opinion is arrived at in part through the use of models (about which the rating agency naturally knows more than the investor) which are susceptible to both honest and dishonest errors. [Model error] 8. Frictions #1, #2, #3, #6, #7 cause subprime crisis 9. Credit rating agencies (CRAs) play an important role by helping to resolve many of the frictions in the securitization process

"Financial Crisis Timeline" by Federal Reserve Bank of St. Louis

Useful reference to keep what happened when straight

Regulatory Response to CDOs

Virtually none as market grew and risks became embedded in balance sheets of financial institutions

"September 2008: The Bailout of AIG" by FCIC

Well researched and well written account of what happened. Focus on what the Fed did and its relationship with the Treasury and TARP 1. Concludes AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a profound failure in corporate governance, particularly its risk management practices 2. AIG's failure was possible because of the sweeping deregulation of over-the-counter (OTC) derivatives, including credit default swaps, which effectively eliminated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG's failure 3. The OTS failed to effectively exercise its authority over AIG and its affiliates: it lacked the capability to supervise an institution of the size and complexity of AIG, did not recognize the risks inherent in AIG's sales of credit default swaps, and did not understand its responsibility to oversee the entire company, including AIG Financial Products 4. AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on credit default swaps and other activities such as securities lending that its potential failure created systemic risk

Evaporation of Net Worth and Risk Taking

When a bank's net worth is gone, management has an incentive to increase risk taking 1. If the gamble pays off, equity holders and performance compensated employees win 2. If it does not, the government insurance fund takes the loss

What Social functions does a financial system perform

When effective, a financial system does the following and in so doing fosters growth and greater welfare: 1. Directs the savings of households and companies to investment in machines, buildings and R&D of businesses and in the houses and consumer durables of households and finances governments 2. Facilitates the management of spending over a lifetime 3. Facilitates risk management through transfer and diversification of risk 4. Provides custody for wealth 5. Facilitates payments for goods and services

Exchanges

Where buyers and sellers of securities or their agents meet to conduct trades

Over-the-counter (OTC) market

Where dealers stand ready to buy and sell securities to anyone who comes their way and is willing to accept the prices